ArnoldKyle IntermFinAcct Vol1 2021A

with Open Texts
Intermediate
Financial
Accounting
Volume 1
G. Arnold & S. Kyle
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Intermediate Financial Accounting
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Author: G. Arnold, S. Kyle
Publisher: Lyryx Learning Inc.
Book title: Intermediate Financial Accounting, Volume 1
Book version: 2021A
Publication date: December 15, 2020
Location: Calgary, Alberta, Canada
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For questions or comments please contact [email protected]

an Open Text by Glenn Arnold & Suzanne Kyle
Base Text Revision History
Current Revision: Version 2021 — Revision A
2021 A • Front matter has been updated including cover, Lyryx with Open Texts, copyright, and revision
pages. Attribution page has been added.
2020 A • Base year for examples and calculations has been updated from 2015 to 2020, and other
dates have been updated to match.
• Minor content fixes throughout.
2019 A • Text updated throughout to reflect new IFRS rules in 2019.

• Links to videos have been added throughout the chapters.
2018 A • Several chapters rewritten to include new IFRS rules effective January 1, 2018.
Table of Contents
Table of Contents iii
1 Review of Intro Financial Accounting 1
Chapter 1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1 Adjusting and Closing Entries . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.2 Merchandising Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.3 Inventory Costing Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.4 Bank Reconciliations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.5 Receivables Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.6 Long-Lived Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.7 Current and Long-Term Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.8 Statement of Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2 Why Accounting? 5
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Chapter Organization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2.1 Definition and Information Asymmetry . . . . . . . . . . . . . . . . . . . . . . . 7
iii
iv Table of Contents
2.2 Trade-Offs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.3 How Are Standards Set? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2.4 The Conceptual Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.4.1 The Objective of Financial Reporting . . . . . . . . . . . . . . . . . . . . 12
2.4.2 Qualitative Characteristics of Useful Information . . . . . . . . . . . . . . 12
2.4.3 Elements of Financial Statements . . . . . . . . . . . . . . . . . . . . . 16
2.4.4 Recognition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
2.4.5 Measurement Base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
2.4.6 Capital Maintenance . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
2.5 Challenges and Opportunities in Financial Reporting . . . . . . . . . . . . . . . 22
2.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
2.7 IFRS/ASPE Key Differences . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
3 Financial Reports: Statement of Income, Comprehensive Income and Changes in

Equity 37
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
3.1 Financial Reporting: Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
3.2 Factors that Influence Financial Reports . . . . . . . . . . . . . . . . . . . . . . 40
3.2.1 Accounting Year-end . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

v
3.2.2 Changes in Accounting Estimates, Changes in Accounting Policy, and

Correction of Errors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
3.3 Financial Statements and Their Interrelationships . . . . . . . . . . . . . . . . . 44
3.3.1 Financial Statement Differences Between IFRS and ASPE . . . . . . . . 48
3.4 Statement of Income and Comprehensive Income . . . . . . . . . . . . . . . . 48
3.5 Statement of Changes in Equity (IFRS) and Statement of Retained Earnings

(ASPE) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
3.6 Analysis of Statement of Income and Statement of Changes in Equity . . . . . . 60
3.7 IFRS and ASPE Applicable Standards . . . . . . . . . . . . . . . . . . . . . . . 62
Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
4 Financial Reports – Statement of Financial Position and Statement of Cash Flows 75
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
4.1 Financial Reports: Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
4.2 Statement of Financial Position/Balance Sheet . . . . . . . . . . . . . . . . . . 80
4.2.1 Disclosure Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . 80
4.2.2 Factors Affecting the Statement of Financial Position/Balance Sheet (SFP/BS) 91
4.3 Statement of Cash Flows (SCF) . . . . . . . . . . . . . . . . . . . . . . . . . . 96
4.3.1 Preparing a Statement of Cash Flows . . . . . . . . . . . . . . . . . . . 98
4.3.2 Disclosure Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . 109
4.3.3 Interpreting the Statement of Cash Flows . . . . . . . . . . . . . . . . . 111

vi Table of Contents
4.4 Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123
5 Revenue 137
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138
5.1 Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139
5.2 Revenue Recognition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140
5.2.1 Identify the Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141
5.2.2 Identify the Performance Obligations . . . . . . . . . . . . . . . . . . . . 142
5.2.3 Determine the Transaction Price . . . . . . . . . . . . . . . . . . . . . . 144
5.2.4 Allocate the Transaction Price to the Performance Obligations . . . . . . 145
5.2.5 Recognize Revenue When (or as) the Entity Satisfies a Performance
Obligation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
5.2.6 Contract Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147
5.3 Applications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
5.3.1 Bundled Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
5.3.2 Consignment Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
5.3.3 Sales With Right of Return . . . . . . . . . . . . . . . . . . . . . . . . . 150
5.3.4 Bill-and-Hold Arrangements . . . . . . . . . . . . . . . . . . . . . . . . . 151
5.3.5 Barter Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
5.3.6 Long-Term Construction Contracts . . . . . . . . . . . . . . . . . . . . . 153

vii
5.4 Presentation and Disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158
5.5 The Earnings Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164
6 Cash and Receivables 169
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171
6.1 Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
6.2 Cash and Cash Equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
6.2.1 Internal Control of Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
6.3 Receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177
6.3.1 Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178
6.3.2 Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191
6.3.3 Derecognition and Sale of Receivables: Shortening the Credit-to-Cash

Cycle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
6.3.4 Disclosures of Receivables . . . . . . . . . . . . . . . . . . . . . . . . . 215
6.4 Cash and Receivables: Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . 217
6.6 Appendix A: Review of Internal Controls, Petty Cash, and Bank Reconciliations 226
Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
viii Table of Contents
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
7 Inventory 253
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 254
7.1 Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255
7.2 Initial Recognition and Measurement . . . . . . . . . . . . . . . . . . . . . . . . 256
7.3 Subsequent Recognition and Measurement . . . . . . . . . . . . . . . . . . . . 258
7.3.1 Inventory Accounting Systems . . . . . . . . . . . . . . . . . . . . . . . 259
7.3.2 Cost Flow Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . 260
7.3.3 The Problem of Overvaluation . . . . . . . . . . . . . . . . . . . . . . . 264
7.4 Presentation and Disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266
7.5 Inventory Errors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 266
7.6 Estimating Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269
7.7 Inventory Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270
Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 276
8 Intercorporate Investments 281
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283

ix
8.1 Intercorporate Investments: Overview . . . . . . . . . . . . . . . . . . . . . . . 284
8.2 Non-Strategic Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
8.2.1 Fair Value Through Net Income (FVNI) . . . . . . . . . . . . . . . . . . . 289
8.2.2 Fair Value Through OCI Investments (FVOCI); (IFRS only) . . . . . . . . 296
8.2.3 Amortized Cost Investments (AC) . . . . . . . . . . . . . . . . . . . . . 306
8.3 Strategic Investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312
8.3.1 Investments in Associates (Significant Influence) . . . . . . . . . . . . . 314
8.3.2 Investments in Subsidiaries (Control) . . . . . . . . . . . . . . . . . . . . 316
8.3.3 Investments in Joint Arrangements . . . . . . . . . . . . . . . . . . . . . 317
8.4 Investments Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 318
8.5 Investments Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 319
Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325
9 Property, Plant, and Equipment 337
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339
9.1 Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 340
9.2 Recognition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341
9.3 Measurement at Recognition . . . . . . . . . . . . . . . . . . . . . . . . . . . . 342
9.3.1 Self-Constructed Assets . . . . . . . . . . . . . . . . . . . . . . . . . . 343

x Table of Contents
9.3.2 Borrowing Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 343
9.3.3 Asset Retirement Obligations . . . . . . . . . . . . . . . . . . . . . . . . 344
9.3.4 Lump Sum Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . 344
9.3.5 Non-monetary Exchanges . . . . . . . . . . . . . . . . . . . . . . . . . 345
9.3.6 Deferred Payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 348
9.3.7 Government Grants . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349
9.4 Measurement After Initial Recognition . . . . . . . . . . . . . . . . . . . . . . . 350
9.4.1 Cost Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350
9.4.2 Revaluation Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 351
9.4.3 Fair Value Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353
9.5 Costs Incurred After Acquisition . . . . . . . . . . . . . . . . . . . . . . . . . . 354
Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 361
10 Depreciation, Impairment, and Derecognition of Property, Plant, and Equipment 367
Chapter 10 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 368
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 368
10.1 Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370
10.2 Depreciation Calculations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370
10.2.1 Depreciable Amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370
10.2.2 Useful Life . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371

xi
10.2.3 Methods of Calculation . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
10.2.4 Separate Components . . . . . . . . . . . . . . . . . . . . . . . . . . . 374
10.2.5 Partial Period Calculations . . . . . . . . . . . . . . . . . . . . . . . . . 375
10.2.6 Revision of Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . 375
10.3 Impairment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376
10.3.1 Accounting for Impairment . . . . . . . . . . . . . . . . . . . . . . . . . 377
10.3.2 Cash-Generating Units . . . . . . . . . . . . . . . . . . . . . . . . . . . 378
10.4 Derecognition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380
10.4.1 Held for Sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380
10.4.2 Other Derecognition Issues . . . . . . . . . . . . . . . . . . . . . . . . . 382
10.5 Presentation and Disclosure Requirements . . . . . . . . . . . . . . . . . . . . 383
10.7 Appendix A: ASPE Standards for Impairment . . . . . . . . . . . . . . . . . . . 384
Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 387
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 390
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 390
11 Intangible Assets and Goodwill 395
Chapter 11 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 395
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 396
11.1 Intangible Assets and Goodwill: Overview . . . . . . . . . . . . . . . . . . . . . 397
11.2 Intangible Assets: Initial Recognition and Measurement . . . . . . . . . . . . . 399

xii Table of Contents
11.2.1 Purchased Intangible Assets . . . . . . . . . . . . . . . . . . . . . . . . 400
11.2.2 Internally Developed Intangible Assets . . . . . . . . . . . . . . . . . . . 400
11.2.3 Intangible Assets: Subsequent Measurement . . . . . . . . . . . . . . . 402
11.2.4 Intangible Assets: Impairment and Derecognition . . . . . . . . . . . . . 404
11.3 Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 406
11.3.1 Initial Recognition and Measurement . . . . . . . . . . . . . . . . . . . . 406
11.3.2 Subsequent Measurement of Goodwill . . . . . . . . . . . . . . . . . . . 409
11.4 Disclosures of Intangible Assets and Goodwill . . . . . . . . . . . . . . . . . . . 410
11.5 Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 411
Chapter Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 413
References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 416
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 417
Solutions To Exercises 427
Chapter 2 Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 427

xiii
Chapter 10 Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 528
Chapter 11 Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 535

Chapter 1
Review of Intro Financial Accounting
Chapter 1 Learning Objectives
LO 1: Complete Review Lab 1.1 to review adjusting entries.
LO 2: Complete Review Lab 1.2 to review merchandising transactions.
LO 3: Complete Review Lab 1.3 to review inventory costing methods.
LO 4: Complete Review Lab 1.4 to review bank reconciliations.
LO 5: Complete Review Lab 1.5 to review receivables transactions.
LO 6: Complete Review Lab 1.6 to review transactions related to long-lived assets.
LO 7: Complete Review Lab 1.7 to review current and long-term liabilities.
LO 8: Complete Review Lab 1.8 to review the statement of cash flows.
Introduction
To be successful in Intermediate Financial Accounting, it is imperative for a student to have a

strong foundational knowledge of all Introductory Financial Accounting concepts. The purpose
of Lesson 1 is to help a student identify any weaknesses in their Intro Accounting knowledge.
Lesson 1 consists of a series of labs intended to help a student identify any knowledge gaps.
If a weakness comes to light, the student is encouraged to go back to that concept in Intro
Accounting and review in detail. It is the student’s responsibility to ensure they come into
Intermediate Financial Accounting with the appropriate pre-requisite knowledge.
Each section will provide a link to the open Introduction to Financial Accounting textbook by
Dauderis and Annand. You may also access the textbook by visiting http://lifa1.lyryx
.com/open_introfa/?LESSONS . You can either view the lessons online, or you will find a
Download link on the left side that will let you download a PDF or order a printed copy of that
textbook. If you used this textbook in your Introductory Financial Accounting course then you
may already have a copy of the textbook.
1
2 Review of Intro Financial Accounting
1.1 Adjusting and Closing Entries
In this section, you will complete the review labs to evaluate your pre-requisite knowledge
related to adjusting and closing entries. If you require a ‘refresher’ on adjusting and/or closing
entries, refer to Chapter 3 of Introductory Financial Accounting.
Link to lessons: http://lifa1.lyryx.com/open_introfa/?LESSONS#ch3
1.2 Merchandising Transactions
In this section, you will complete the review labs to evaluate your pre-requisite knowledge re-
lated to merchandising transactions. If you require a ‘refresher’ on merchandising transactions,
refer to Chapter 5 of Introductory Financial Accounting.
1.3 Inventory Costing Methods
related to inventory costing methods. If you require a ‘refresher’ on inventory costing methods,
1.4 Bank Reconciliations
related to bank reconciliations. If you require a ‘refresher’ on bank reconciliations, refer to
Chapter 7 of Introductory Financial Accounting.

1.5. Receivables Transactions 3
1.5 Receivables Transactions
related to receivables transactions. If you require a ‘refresher’ on receivables transactions,
1.6 Long-Lived Assets
related to long-lived assets. If you require a ‘refresher’ on long-lived assets, refer to Chapter 8
of Introductory Financial Accounting.
1.7 Current and Long-Term Liabilities
related to current and long-term liabilities. If you require a ‘refresher’ on current and long-term
liabilities, refer to Chapter 9 of Introductory Financial Accounting.
1.8 Statement of Cash Flows
related to the statement of cash flows. If you require a ‘refresher’ on the statement of cash
flows, refer to Chapter 11 of Introductory Financial Accounting.

Chapter 2
Why Accounting?
It Was No Joke
Perhaps the timing was intentional. On April 2, 2009, the Financial Accounting Standards
Board (FASB) in the United States voted to amend the accounting rules for financial
instruments. In particular, the changes in the rules allowed banks and their auditors to
apply “significant judgment” in the valuation of certain illiquid mortgage assets.
The issue arose directly as a result of the 2008 financial crisis. After the housing bubble
of the early- to mid-2000s burst, resulting in the failure of several prominent financial
institutions, many of the remaining banks were left with mortgage-backed securities that
could not be sold. Existing accounting rules for financial instruments required those instru-
ments be valued at the fair value, sometimes referred to as mark-to-market accounting.
Unfortunately, many of these assets no longer had a market, and accountants were forced
to report these assets at their "distressed" values.
The banking industry did not like this accounting treatment. Many industry lobbyists
complained that a security that was backed by identifiable cash flows still had a value, even
if it were currently unmarketable. They were concerned that reporting these distressed
values in the financial statements would lower reported profits and further damage the
already-weakened confidence in the banking sector. The banking industry lobbied law-
makers aggressively to put pressure on the FASB to change the rules. In the end, they
succeeded, and the FASB made changes that allowed for alternative valuation techniques.
The application of these techniques would result in higher profits than would have been
reported under the old rules.
Although the banking industry was somewhat satisfied with this result, critics noted that the
new rules gave the banks more latitude to report results that were less transparent and
possibly less representative of economic reality. There is much at stake when financial
results are reported, and accountants face pressures from parties both inside and outside
the business to manipulate those results to achieve certain goals. Accountants need a
solid foundation of rules and principles to rely on in making the judgments necessary when
preparing financial statements. However, accounting standard setting can, at times, be a
political process, and the practicing accountant needs to be aware that the profession’s
thoughtful principles may not always provide all the solutions.
(Source: Orol, 2009)
5
6 Why Accounting?
After completing this chapter, you should be able to:
LO 1: Identify the purpose of financial reporting.
LO 2: Describe the problem of information asymmetry, and discuss how this problem can
affect the production of financial information.
LO 3: Describe how accounting standards are set in Canada and identify the key entities
that are responsible for setting standards.
LO 4: Discuss the purpose of the conceptual framework, and identify the key components of
the framework.
LO 5: Describe the qualitative characteristics of accounting information.
LO 6: Identify the elements of financial statements.
LO 7: Discuss the criteria required for recognizing an element in financial statements.
LO 8: Identify different measurement bases that could be used, and discuss the strengths
and weaknesses of each base.
LO 9: Identify the alternative models of capital maintenance that could be applied.
LO 10: Discuss the relative strengths and weaknesses of rules-based and principles-based
accounting systems.
LO 11: Discuss the possible motivations for management bias of financial information.
LO 12: Discuss the need for ethical behaviour by accountants, and identify the key elements
of the codes of conduct of the accounting profession.
LO 13: Explain the effects on the accounting profession of changes in information technology.
Introduction
The profession and practice of accounting has seen tremendous changes since the turn of
the new millennium. A series of accounting scandals in the early 2000s, followed by the
tremendous upheaval in capital markets and the world economy that resulted from the 2008
meltdown of the financial services industry, has led many to question the purpose and value of
accounting information. In this chapter, we will examine the nature and purpose of accounting
information and the key challenges faced by those who create accounting standards. We
Chapter Organization 7
will also examine the accounting profession’s response to those challenges, including the
conceptual framework that currently shapes the development of accounting standards. We
will also discuss the role of ethical behaviour in the accounting profession and the issues
faced by practicing accountants.
Chapter Organization
1.0 Definition and

Information Asymmetry
The Objective of
Financial Reporting
2.0 Trade-offs
Qualitative Characteristics
3.0 How are
Standards Set?
Elements of
Financial Statements
Why Accounting? 4.0 The Conceptual
Framework
Recognition
5.0 Challenges and
Opportunities in
Financial Reporting
Measurement Base
6.0 Conclusion
Capital Maintenance
7.0 IFRS/ASPE
Key Differences
2.1 Definition and Information Asymmetry
The International Accounting Standards Board (IASB) has stated that the purpose of financial
reporting is “to provide financial information about the reporting entity that is useful to exist-
ing and potential investors, lenders and other creditors in making decisions about providing
resources to the entity. Those decisions involve buying, selling or holding equity and debt
instruments, providing or settling loans and other forms of credit, or exercising rights to vote
on, or otherwise influence, management’s actions that affect the use of the entity’s economic
resources.” (International Accounting Standards Board, 2019). The key elements of this
definition are that information must be useful and that it must assist in the decision-making
function. Although this primary definition identifies investors, lenders, and creditors as the
8 Why Accounting?
user groups, the IASB does acknowledge that other users may also find financial statements
useful. The IASB also acknowledges two key characteristics of the financial-reporting en-
vironment. First, most users, such as shareholders or lenders, do not have the ability to
access information directly from the reporting entity. Thus, those users must rely on general-
purpose financial statements as well as other sources to obtain the information. Second,
management of the company has access to more information than the external users, as they
can access internal, nonpublic sources from the company’s records. These two conditions
result in information asymmetry, which is a key concept in understanding the purpose and
development of accounting standards.
Information asymmetry simply means that one individual has more information than another
individual. This concept is very easy to understand and is obviously true in all kinds of
interactions that occur in your life on a daily basis. When you enter the room to write an
exam, you know how much sleep you had the night before and what you ate for breakfast, but
your professor does not. This type of information advantage is not very useful to you, however,
as your professor is interested only in what you write on your exam paper, not the conditions
that led up to those responses. In other cases, however, it is possible that you could gain an
information advantage that could be useful to your performance on the exam. In the broader
perspective of financial accounting, we are concerned the implications and problems that may
be caused by information asymmetry. To explore this concept further, we need to consider two
different forms of information asymmetry: adverse selection and moral hazard.
Adverse selection occurs because employees and managers of a company have more knowl-
edge of the company’s operations than the general public and, more specifically, investors.
Because these individuals know more about the company and its potential future profitability,
they may be tempted to take advantage of this knowledge. For example, if a manager of a
company knew that a contract had just been signed with a new customer that was going to
significantly increase revenues in the following year, the manager may be tempted to purchase
shares of the company on the open market before the contract is announced to the public.
By doing so, the manager may benefit when the news of the contract is released and the
price of the share rises. In this case, the manager has unfairly used his or her information
advantage to gain a personal benefit, which can be considered adverse to the interests of other
investors. Because investors are aware of this potential problem, they may lose confidence in
the securities market. This could result in investors generally paying less for shares than may
be warranted by the fundamental factors of the business. The investors would do this because
they wouldn’t completely trust the information they were receiving. If this lack of confidence
became serious or widespread, it is possible that securities markets wouldn’t function at all.
The field of financial accounting clearly has a role in trying to solve the adverse selection prob-
lem. By making sufficient, high-quality information available to investors in a timely manner,
accountants can reduce the adverse effects of this form of information asymmetry. However,
it is impossible to eliminate the problem completely, as insiders of a company will always
receive the information first. The accounting profession must thus work toward cost-effective
and reasonable (but imperfect) solutions to convey useful information to investors.
2.2. Trade-Offs 9
Moral hazard is a different type of problem caused by an information imbalance. Except for
very small businesses, most companies operate under the principle of separation of ownership
and management. Shareholders can be numerous and geographically diverse; it is impossible
for them to be directly involved in the running of the business. To solve this problem, share-
holders hire managers to act as stewards of their investment. One feature of corporate law
is the presumption that managers will always work toward the best interests of the company.
Shareholders assume this to be true, but they do not have a very effective method of directly
observing manager behaviour. Managers know this; thus, there may be an incentive – or at
least an opportunity – not to work as hard or as effectively as the shareholders would like. If
the company’s performance suffers because of poor manager effort, the manager can always
blame outside factors or other economic conditions. In extreme cases, the manager may even
be tempted to manipulate financial reports to cover up poor performance.
To give shareholders the ability to monitor manager performance, financial accounting must
seek ways to provide financial performance measures. Many analytical techniques use finan-
cial accounting as a basis for the calculations. However, shareholders must have confidence
not only in the accuracy of the information but also in the usefulness of the information for
evaluation of management stewardship. Again, there is no perfect solution here, as the
complexities and qualitative features of management activity can never be perfectly captured
by numbers alone. Still, financial accounting information can help investors assess the quality
of the managers they hire, which can potentially reduce the moral hazard problem.
2.2 Trade-Offs
As suggested in the previous section, accounting can play a role in reducing both adverse
selection and moral hazard. However, because these two problems relate to two different
user needs (i.e., the need to predict future investment performance and the need to evaluate
management stewardship), it is unlikely that accounting information will always be perfectly
and simultaneously useful in alleviating these problems. For example, information about the
current values of assets may help an investor better predict the future economic prospects
of the company, particularly in the short term. However, current values may not reveal much
about management stewardship, as managers have very little control over market conditions.
Similarly, the depreciated historical cost of property, plant, and equipment assets can re-
veal something about management’s decision-making processes regarding the purchase and
use of these assets, but historical costs provide very little value in estimating future returns.
Accounting standard setters recognize that any specific disclosure may not meet all users’
needs, and as such, trade-offs are necessary in setting standards. Sometimes trade-offs
between different user purposes are required, and sometimes the trade-off is simply a matter of
evaluating the cost of producing the information compared with the benefit received. Because
of these trade-offs, accounting information must be viewed as an imperfect solution to the
problem of information asymmetry. Still, those who set accounting standards attempt to create
the framework for the production of information that will be useful to all readers, in particular to
10 Why Accounting?
the primary user groups of investors, lenders, and creditors.
2.3 How Are Standards Set?
In Canada, the Accounting Standards Board (AcSB) sets accounting standards. The AcSB is
an independent body whose members are appointed by the Accounting Standards Oversight
Council (AcSOC). The AcSOC was established in 2000 by the Canadian Institute of Chartered
Accountants (CICA) to oversee the standard setting process. Currently the AcSB receives
funding, staff, and other resources from the Chartered Professional Accountants of Canada
(CPA Canada).
Two distinct sets of accounting standards for profit-oriented enterprises exist in Canada: Inter-
national Financial Reporting Standards (IFRS) for those entities that have public accountability
and Accounting Standards for Private Enterprises (ASPE) for those entities that do not have
public accountability.
The CPA Canada Handbook defines a publicly accountable enterprise as follows:
An entity, other than a not-for-profit organization, that:

I. has issued, or is in the process of issuing, debt or equity instruments that are,
or will be, outstanding and traded in a public market (a domestic or foreign
stock exchange or an over-the-counter market, including local and regional
markets); or
II. holds assets in a fiduciary capacity for a broad group of outsiders as one of
its primary businesses. (CPA Canada, 2016)
Entities included in the second category can include banks, credit unions, investment dealers,
insurance companies, and other businesses that hold assets for clients. For most of the
illustrative examples in this text, we will assume that publicly traded companies use IFRS and
that private companies use ASPE. Note that companies that do not have public accountability
may still elect to use IFRS if they like. They may choose to do this if they intend to become
publicly traded in the future or have some other reporting relationship with a public company.
ASPE are formulated solely by the AcSB and are designed specifically for the needs of
Canadian private companies. IFRS, on the other hand, are created by the IASB and are
adopted by the AcSB. The AcSB is actively involved with the IASB in the development of
IFRS, and most IFRS are adopted directly into the CPA Canada Handbook – Accounting. In
some rare circumstances, however, the AcSB may determine that a particular IFRS does not
adequately meet the reporting needs of Canadian businesses and may thus choose to “carve
out” this particular section before including the standard in the CPA Canada Handbook.
2.4. The Conceptual Framework 11
The IASB was formed for the purpose of harmonizing international accounting standards.
This concept makes sense, as the past few decades have seen increased international trade,
improvement of technologies, and other factors that have made capital more mobile. Investors
who want to make choices between companies in different countries need to have some confi-
dence that they will be able to compare reported financial results. The IASB has attempted to
provide this assurance, and the use of IFRS around the world continues to grow, with partial
or full convergence now in more than 140 countries.
For Canadian accountants, it is important to note that the United States still has not converged
its standards with IFRS. Canada has a significant amount of cross-border trade with the United
States, and many Canadian companies are also listed on American stock exchanges. In the
United States, accounting standards are set by the Financial Accounting Standards Board
(FASB), although the actual legal authority for standard setting rests with the Securities and
Exchange Commission (SEC). The FASB has indicated in the past that it wishes to work with
IASB to find a way to converge its standards with the international model. However, the FASB’s
standards are quite detailed and prescriptive, which makes convergence difficult. As well, a
number of political factors have prevented convergence from occurring. As this point, it is
difficult to predict when or if the FASB will converge its standards with the IASB.
2.4 The Conceptual Framework
According the CPA Canada Handbook, “the purpose of the Conceptual Framework is to:
a) assist the International Accounting Standards Board to develop IFRS Standards that are
based on consistent concepts;
b) assist preparers to develop consistent accounting policies when no Standard applies to

a particular transaction or other event, or when a Standard allows a choice of accounting
policy; and
c) assist all parties to understand and interpret the Standards.” (CPA Canada, 2019).
A solid, coherent framework of principles is important not only to standard setters who need
to develop new principles in response to changes in the business environment but also to
practicing accountants who may encounter unusual or unique types of business transactions
on a daily basis.
The IASB and the FASB had been working on a joint conceptual framework for several years,
but this project was replaced by an IASB-only project, which was completed in 2018. This
framework is currently used in Canada for publicly accountable enterprises. The conceptual
12 Why Accounting?
framework used for private enterprises is very similar in content, although the structure, termi-
nology, and emphasis differ slightly. We will focus on the IASB framework, which is located in
Part 1 of the CPA Canada Handbook.
2.4.1 The Objective of Financial Reporting
The conceptual framework opens with a statement of the purpose of financial reporting, which
was discussed previously in this chapter. Recall that the key components of this definition are
that financial information must be useful for making decisions, primarily about investment or
lending of resources to a business entity, or evaluation of management stewardship. The con-
ceptual framework then proceeds to discuss the qualitative characteristics of useful accounting
information.
2.4.2 Qualitative Characteristics of Useful Information
The conceptual framework identifies fundamental and enhancing qualitative characteristics of

useful information.
The fundamental characteristics are
• relevance and
• faithful representation.
The enhancing characteristics are
• comparability,
• verifiability,
• timeliness, and
• understandability.
Fundamental Characteristics
Relevance means that information is “capable of making a difference in the decisions made by
users” (CPA Canada, 2019, QC2.6). The definition is further refined to state that information is
capable of influencing decisions if it has predictive value, confirmatory value, or both. Predic-
tive value means that the information can be used to assist in the process of making predictions
about future events, such as potential investment returns, credit defaults, and other decisions
that financial-statement users need to make. Note that although the information may assist in
these decisions, the information is not in itself a prediction or forecast. Rather, the information
is the raw material used by the decision maker to make the prediction. Confirmatory value
means that the information provides some feedback about previous decisions that were made.
Quite often, the same information may be useful for prediction and feedback purposes, but
in different time periods. An income statement may help an investor decide to invest in a
company this year, and next year’s income statement, when released, will provide feedback as
to whether the investment decision was correct. The framework also mentions the concept of
materiality. A piece of information is considered material if its omission would affect a user’s
decision. Materiality is a concept used frequently by both internal accountants and auditors
in determining the need to make adjustments for errors identified. Clearly, an item that is not
deemed to be material is not relevant, as it would not affect a user’s decision.
Faithful representation means that the financial information presented represents the true
economic substance or state of the item being reported. This does not mean, however, that
the representation must be 100 percent accurate, as perfection is rarely attainable. The CPA
Handbook indicates that for information to faithfully represent an economic phenomenon, it
must be complete, neutral, and free from error.
Information is complete if there is sufficient disclosure for the reader to understand the under-
lying phenomenon or event. This means that many financial disclosures will require additional
explanations that go beyond a mere reporting of the quantitative values. Completeness is the
motivation behind many of the note disclosures contained in financial statements. Because
financial-statement users are trying to make predictions about future events, more detail is
often needed than simply the balance sheet or income-statement amount. For example, if
an investor wanted to understand a manufacturing company’s requirements for future replace-
ment of property, plant, and equipment assets, detailed information about the remaining useful
lives of the assets and related depreciation periods and methods would be needed. Similarly,
if a creditor wanted to assess the possible future effect on cash flows of a lease agreement,
detailed information about the term of the lease, the required payments, and possible renewal
options would be needed.
The neutrality concept suggests that the information is not biased and does not favour one
particular outcome or prediction over another. This can often be difficult to assess, as many
judgments are required in some accounting measures. There are many motivations for man-
agers and preparers of financial statements to bias or influence the reporting of certain results.
These motivations will be discussed later in this chapter. The professional accountant’s role
is to ensure that these biases are understood and controlled so that the reported financial
results are not misleading to readers. Neutrality can also be supported by the use of prudent
judgment. “Prudence is the exercise of caution when making judgments under conditions
of uncertainty” (CPA Canada, 2019, QC2.16). Prudence has historically been described
as a cautious attitude that does not allow for the overstatement of assets or income, or an
14 Why Accounting?
understatement of liabilities or expenses. However, the definition in the Conceptual Frame-

work equally suggests that assets or income should not be understated and that liabilities or
expenses should not be overstated. The Framework makes this explicit statement to suggest
that asymmetry in standards is not necessary. However, there are examples of specific
standards in IFRS that do have unbalanced requirements (i.e. have a requirement for more
persuasive evidence when recognizing an income compared to an expense). These types of
unbalanced standards are considered acceptable if they result in more relevant and faithfully
representative information. The application of prudence obviously takes a high degree of skill
and professional judgment. Prudence is not considered a qualitative characteristic on its own,
but is rather, sound advice to the practicing accountant.
As noted previously, information that is free from errors is not a guarantee of certainty or 100
percent accuracy. Rather, this criterion suggests that the economic phenomenon is accurately
described and the process at arriving at the reported amount has properly applied. There is still
the possibility that a reported amount could be incorrect. For example, at the end of the fiscal
year, many companies will make an allowance for doubtful accounts to reflect the possibility
that some accounts receivable will not be collected. At the balance sheet date, there is no way
to be 100 percent certain that the reported allowance is correct. Only the passage of time will
reveal the truth about this estimate. However, we can still say that the allowance is free from
error if we can determine that a logical and consistent process has been applied to determine
the amount and that this process is adequately described in the financial statements. This
way, readers are able to make their own assessments of the risks involved in collecting these
future cash flows.
It should be noted that the presence of both of the fundamental characteristics is required for
information to be useful. An error-free representation of an irrelevant phenomenon is not much
use to financial-statement readers. Similarly, if a relevant measure cannot be described with
any degree of accuracy, then users will not find this information very useful for predicting future
cash flows.
Enhancing Characteristics
The conceptual framework describes four additional qualitative characteristics that should
enhance the usefulness of information that is already determined to be relevant and faithfully
represented. These characteristics are comparability, verifiability, timeliness, and understand-
ability.
Comparability is the quality that allows readers to compare either results from one entity with
another entity or results from the same entity from one year with another year. This quality
is important because readers such as investors are interested in making decisions whether
to purchase one company’s shares over another’s or to simply divest a share already held.
One key component of the comparability quality is consistency. Consistency refers to the use
of the same method to account for the same items, either within the same entity from one
period to the next or across different entities for the same accounting period. Consistency in
application of accounting principles can lead to comparability, but comparability is a broader
concept than consistency. Also, comparability must not be confused with uniformity. Items that
are fundamentally different in nature should be accounted for differently.
The verifiability quality suggests that two or more independent and knowledgeable observers
could come to the same conclusion about the reported amount of a particular financial-statement
item. This does not mean that the observers have to be in complete agreement with each
other. In the case of an estimated amount on the financial statements, such as an allowance for
doubtful accounts, it is possible that two auditors may agree that the amount should fall within a
certain range, but each may have different opinion of which end of the range is more probable.
If they agree on the range, however, we can still say the amount is verifiable. Verification
may be performed by either directly observing the item, such as examining a purchase invoice
issued by a vendor, or indirectly verifying the inputs and calculations of a model to determine
the output, such as reviewing the assumptions and recalculating the amount of an allowance
for doubtful accounts by using data from an aged trial balance of accounts receivable.
Timeliness is one of the simplest but most important concepts in accounting. Generally,
information needs to be current to be useful. Investors and other users need to know the
economic condition of the business at the present moment, not at some previous period.
However, past information can still be useful for tracking trends and may be especially useful
for evaluating management stewardship.
Understandability is the one characteristic that the accounting profession has often been ac-
cused of disregarding. It is generally assumed that readers of financial statements should have
a reasonable understanding of business issues and basic accounting terminology. However,
many business transactions are inherently complex, and the accountant faces a challenge
in crafting the disclosures in such a way that they completely and concisely describe the
economic nature of the item while still being comprehensible. Financial disclosures should
be reviewed by non-specialist, knowledgeable readers to ensure the accountant has achieved
the quality of understandability.
As mentioned previously, accountants are often faced with trade-offs in preparing financial
disclosures. This is especially true when considering the application of the various qualitative
characteristics. Sometimes, the need for timeliness may result less-than-optimal verifiability,
as verification of some items may require the passage of time. As a result, the accountant is
forced to make estimations in order to ensure the information is available within a reasonable
time. As well, all information has a cost, and companies will carefully consider the cost of
producing the information compared with the benefits that can be obtained from the informa-
tion, such as improving relevance or faithful representation. These challenges point to the
conclusion that accounting is an imperfect measurement system that requires judgment in
both the preparation and interpretation of the information.
16 Why Accounting?
2.4.3 Elements of Financial Statements
The CPA Canada Handbook includes a section describing a number of essential financial-
statement elements. This section is not intended to be an exhaustive list of each item that
could appear on the financial statements. Rather, it describes broad categories of financial-
statement elements and defines them using key concepts that identify the essential elements
of each category. These broadly based definitions will require the accountant to use judgment
in the determination of the nature and the specific treatment and disclosure of business trans-
actions. However, the accountant’s judgment can also help ensure that financial statements
properly reflect the underlying economic nature of the transaction, not just the legal form that
may have been designed to circumvent more specific rules.
An Underlying Assumption
Before commencing a detailed examination of elements of financial statements, it is important

to understand the key assumption underlying the reporting process. It is normally assumed
that companies are operating as a going concern. This means that the company is expected to
continue operating into the foreseeable future and that there will be no need to liquidate signif-
icant portions of the business or otherwise materially scale back operations. This assumption
is important, because a company that is not a going concern would likely need to apply a
different method of accounting in order not to be misleading. If a company needed to liquidate
equipment at a substantial discount due to bankruptcy or other financial distress, it would not
be appropriate to carry those assets at depreciated cost. In situations of financial distress,
the accountant needs to carefully consider the going-concern assumption in determining the
correct accounting treatment.
Assets
An asset is the first financial-statement element that needs to be considered. In the simplest
sense, an asset is something that a business owns. The CPA Canada Handbook defines an
asset as “a present economic resource controlled by the entity as a result of past events” (CPA
Canada, 2019, 4.3). The definition further states that an economic resource is a right that
can produce economic benefits. The key point in this definition is that economic benefits are
expected to be received at some point in the future as a result of holding the resource. The
most obvious benefit is the future inflow of cash. This can be seen very clearly with an item
such as inventory held by a retail store, as the store expects to sell the items in a short period
of time to generate cash. However, an asset could also be a piece of equipment installed in
a factory that reduces the consumption of electricity by production processes. Although this
equipment will not directly generate a future cash inflow, it does reduce a future cash outflow.
This is also considered an economic benefit. The use of the term “right” in the definition also
suggests other types of relationships, such as the right to use a patented process or the right
to receive a favourable amount under a derivative contract. Rights are often established by a
legal contract or enacted legislation, but there are other ways that rights can be considered
assets, even without legal form. It is also important to note that the right must be capable
of producing benefits beyond those available to other parties. An artistic work that is legally
available in the public domain cannot be considered an asset to an entity, since other parties
can also equally access the work.
Many assets have a tangible, or physical, form. However, some assets, such as accounts
receivable or a patent, have no physical form. In the case of an account receivable from a
customer, the future benefit results from the legal right the company holds to enforce payment.
For a patent, the future benefit results from the company’s ability to sell its product while
maintaining some protection from competitors. Cash in a bank account does not have physical
form, but it can be used as a medium of exchange.
It should also be noted that, although we can generally think of assets as something we own,
the actual legal title to the resource does not necessarily need to belong to the company for it
to be considered an asset. A contract, such as a long-term lease that conveys benefits to the
leasing party over a significant portion of the asset’s useful life may be considered an asset in
certain circumstances.
Liabilities
A liability is defined as “a present obligation of the entity to transfer an economic resource as

a result of past events.” (CPA Canada, 2019, 4.26). This definition can be visualized through
a time-continuum graphic:
Past EVENT Present OBLIGATION Future TRANSFER
When we prepare a balance sheet, it represents the present moment, so the obligation gets
reported as a liability. This obligation is often a legal obligation, as in the case when goods
are purchased on account, resulting in an accounts payable entry, or when money is borrowed
from a bank, resulting in a loan payable. As well, this legal obligation can exist even in the
absence of a formal contract. A company still has to report wages payable for any work
performed by an employee but not yet paid, even if that work was performed under the terms
of an informal, casual labour agreement.
Liabilities can also result from common business practice or custom, even if there is no legally
enforceable amount. If a retailer of mobile telephones agrees to replace one broken screen
per customer, then the expected cost of these replacements should be reported as a liability,
even if the damage resulted from the customer’s neglect and there is no legal obligation to pay.
This type of liability is referred to as a constructive obligation. As well, companies may record
18 Why Accounting?
liabilities based on equitable principles. If a company significantly reduces its workforce, it may
feel a moral obligation to provide career transition counselling to its laid-off employees, even
though there is no legal obligation to do so. In general, an obligation is considered a duty or
responsibility that an entity has no practical ability to avoid.
The settlement of the liability usually involves the future transfer of cash, but it can also be
settled by transferring other assets. As well, liabilities are sometimes settled through the
provision of services in the future. A health club that requires its members to pay for one
year’s fees in advance has an obligation to make the facilities available to its members for that
time. Less common ways to settle liabilities include replacing the liability with a new liability and
converting the liability into equity of the business. It should be noted that the determination of
the value of the liability to be recorded sometimes requires significant judgment. An example
of this would be the obligation under a pension plan to make future payments to retirees. We
will discuss this estimation problem in more detail in later chapters dealing with liabilities.
Equity
Equity is the owners’ residual interest in the business, representing the remaining amount
of assets available after all liabilities have been settled. Although equity can be thought of
as a balancing figure, it is usually subdivided into various categories when presented on the
balance sheet. Many of these classifications are related to legal requirements regarding the
ownership interest. The usual categories of equity include share capital, which can include
common and preferred shares, retained earnings, and accumulated other comprehensive
income (IFRS only). However, other types of equity can arise on certain types of transactions,
such as contributed surplus, appropriated retained earnings, and other reserves that may
be allowed under local law. The purpose of all these subcategories of equity is to give
readers enough information to understand how and when the owners may be able to receive
a distribution of their interests. For example, restrictions on retained earnings or levels of
preferences on shares issued may constrain the future payment of dividends to common
shareholders. A potential investor would want to know this before investing in the company.
It should also be noted that the company’s reported equity does not represent its value, either
in a real sense or in the market. The prices that shares trade at in the stock market represent
the cumulative decisions of investors, based on all information that is available. Although
financial statements form part of this total pool of information, there are so many other factors
used by investors to value a company that it is unlikely that the market value of a company
would equal the reported amount of equity on the balance sheet.
Income
Income is defined as “increases in assets, or decreases in liabilities, that result in increases

in equity, other than those relating to contributions from holders of equity claims.” (CPA
Canada, 2019, 4.68). Notice that the definition is based on presence of changes in assets
or liabilities, rather than on the concept of something being earned. This represents the
balance sheet approach used in the conceptual framework, which considers any measure
of performance, such as profit, to simply be a representation of the change in balance sheet

amounts. This perspective is quite different from some historical views adopted previously in
various jurisdictions, which viewed the primary purpose of accounting to be the measurement
of profit (an income-statement approach).
Income can include both revenues and gains. Revenues arise in the course of the normal
activities of the business; gains arise from either the disposal of noncurrent assets (realized
gains) or the revaluation of noncurrent assets (unrealized gains). Unrealized gains on certain
types of assets are usually included in other comprehensive income, a concept that will be
discussed in later chapters.
Expenses
Expenses are defined as “decreases in assets, or increases in liabilities, that result in de-
creases in equity, other than those relating to distributions to holders of equity claims.” (CPA
Canada, 2019, 4.69). Note that this definition is really just the inverse of the definition of
income. Similarly, expenses can include those that are incurred in the regular operation of the
business and those that result from losses. Again, losses can be either realized or unrealized,
and the definition is the same it was for gains.
2.4.4 Recognition
Items are recognized in financial statements when they meet the definition of a financial state-
ment element. (CPA Canada, 2019, 5.6). However, the Conceptual Framework acknowledges
that there may be circumstances when an item that meets the definition of an element is
still not recognized, because doing so would not provide useful information. In referencing
usefulness, the Framework is acknowledging the fundamental qualitative characteristics of
relevance and faithful representation. If it is uncertain whether an asset or liability exists,
or if the probability of an inflow or outflow of economic benefits is low, it is possible that
recognition is not warranted, since the relevance of the information is questionable. Similarly, if
the measurement uncertainty present in estimated amounts were too great, the element would
not be faithfully represented, and accordingly, should not be recognized. It is also possible that
if the costs of recognition outweigh the benefits to users of the financial statements, the item
will not be recognized.
Recognition means the item is included directly in one of the financial statements and not
simply disclosed in the notes. However, if an item does not meet the criteria for recognition, it
may still be necessary to disclose details in the notes to the financial statements. A pending
lawsuit judgment at the reporting date may not meet the criterion of measurement certainty,
but the possible future impact of the event could still be of interest to readers.
20 Why Accounting?
2.4.5 Measurement Base
The Conceptual Framework also notes that once recognition is affirmed, the appropriate
measurement base needs to be considered. The following measurement bases are identified
in the conceptual framework:
• Historical cost
• Current value, which includes
– Fair value
– Value in use/fulfilment value, and
• Current cost
Historical cost is perhaps the most well-entrenched concept in accounting. This simply means
that items are recorded at the actual amount of cash paid or received at the time of the
original transaction. This concept has persisted in accounting thought for so long because of
its relative reliability and verifiability. However, the concept is often criticized because historical
cost information tends to lose relevance as time passes. This can be particularly true for
long-lived assets, such as real estate.
The current value concept results in elements being reported at amounts that reflect cur-
rent conditions at the measurement date. This measurement base tries to achieve greater
relevance by using current information, but it may not always be possible to represent this
information faithfully when active markets for the item do not exist. It may be very difficult to
find the current cost of a unique or specialized asset that was purpose built for a company.
Fair value is the price that would be received to sell an asset, or paid to transfer a liability, in
an orderly transaction between market participants at the measurement date (CPA Canada,
2019, 6.12). This amount can be easily determined when active markets exist. However, if
there is no active market for the item in question, the fair value may still be estimated using a
discounted cash flow technique. Obviously, the more assumptions required in deriving the fair
value, the more measurement uncertainty will exist.
Value in use is also a discounted cash flow technique. It differs from fair value in that it uses
entity specific assumptions, rather than market assumptions. In other words, the entity projects
future cash flows based on the specific way it uses the asset in question, rather than cash flows
based on market assumptions about the use of the asset. In many cases, fair value and value
in use may result in the same valuation, but this is not necessarily true in all cases.
Current cost is the cost to acquire an equivalent asset at the measurement date. This cost
will include any transaction costs to acquire the asset, and will take into consideration the age
and condition of the asset, along with other factors. Current cost represents an entry value,
while fair value and value in use represent exit values.
All of the measurement bases identified have both strengths and weaknesses in terms of their
overall decision usefulness for readers. Thus, there are always trade-offs and compromises
evident when accounting standards are set. It is not surprising, then, to see that current
accounting standards are a hybrid, or conglomeration, of these different bases. Historical cost
is still the most common base used, but many accounting standards for specific items will allow
or require other bases as well.
It should be noted that the Conceptual Framework’s discussion of measurement bases should
be read in conjunction with IFRS 13 – Fair Value Measurement. While the Conceptual Frame-
work provides a broad overview of possible measurement bases, IFRS 13 provides more
specific guidance on how to determine fair value. Fair value is a concept that is applied to
a number of different accounting transactions under IFRS. IFRS 13 suggests that valuation
techniques should maximize the use of observable inputs and minimize the use of unobserv-
able inputs. The standard further applies a hierarchy to those inputs to assist the accountant
in assessing the quality of the data used for valuation. Level 1 of the hierarchy represents
unadjusted, quoted prices in active markets for identical assets or liabilities. Level 2 inputs are
those that are directly or indirectly observable but do not meet the definition of Level 1. This
could include quoted prices from inactive markets or quoted prices for similar (but not identical)
assets. Level 3 inputs are those that are unobservable. In this case, valuation techniques that
require the use of assumptions and calculations of future cash flows may be required. IFRS 13
recommends that Level 1 inputs should always be used where possible. Unfortunately, Level
1 inputs are often unavailable for many assets. The application of fair-value accounting as
described in IFRS 13 will be discussed in more detail in subsequent chapters.
2.4.6 Capital Maintenance
The last section of the conceptual framework deals with the concept of capital maintenance.
This is a broader economic concept that attempts to define the level of capital or operating
capability that investors would want to maintain in a business. This is important for investors
because they ultimately want to earn a return on their invested capital in order to achieve
growth in their overall wealth. However, measuring this growth will depend on how capital is
defined.
The conceptual framework identifies two broad approaches to this question. The measurement
of the owners’ wealth can be defined in terms of financial capital or in terms of physical
capital.
Financial capital maintenance is measured simply by the changes in equity reported on the
company’s balance sheet. These changes can be measured either in terms of money invested
or in terms of purchasing power. The monetary interpretation is consistent with the approach
22 Why Accounting?
used in historical cost accounting, where wealth is measured in nominal units (dollars, euros,
etc.). This is a simple and reasonable approach in the short term, but over longer periods,
monetary values are less relevant due to inflation. A dollar in 1950 could purchase much more
than it could in 2020, so comparisons of capital over longer periods become meaningless.
One way to get around this problem is to apply a constant purchasing power model to capital
maintenance. This attempts to apply a broad-based index, such as the Consumer Price Index,
to equity in order to adjust for the effects of inflation. This should make financial results more
comparable over time. However, it is very difficult to conclude that a broad-based index is
representative of the actual level of inflation experienced by the company, as the company
would be selling and purchasing goods that are different from those included in the index.
The concept of physical capital maintenance attempts to get around this problem by measuring
productive capacity. If a company can maintain the same level of outputs year after year, then
it can be said that capital is maintained, even if the nominal monetary amounts change. This
approach essentially represents the rationale behind the current cost-measurement base. The
difficulty in using this approach is that current cost information about each specific asset in the
business would be prohibitively expensive to obtain. If, instead, the company tried to apply a
general index of prices for its specific industry, it is unlikely that this index would accurately
match the specific asset composition of the company.
The conceptual framework concludes that the framework will not prescribe or require a specific
model because there are so many trade-offs required in determining the appropriate capital
maintenance model. Rather, the framework suggests that needs of financial-statement users
should be considered in determining the appropriate model.
2.5 Challenges and Opportunities in Financial Reporting
As noted in the introduction to this chapter, confidence in financial markets and the accounting
profession were shaken in the early 2000s. A series of accounting scandals, perhaps most
notably Enron Corporation’s, resulted in questioning the role of the information providers and
the need for further regulation. One response, indeed, to these problems was the introduction
of further regulation. In the United States, the Sarbanes-Oxley Act (SOX) was introduced in
2002 to restore the confidence in financial markets that had been so badly shaken after the
accounting scandals. This legislation tightened up auditor independence rules, introduced
new levels of oversight, created additional penalties for company executives engaged in fraud-
ulent reporting, and improved other disclosure requirements. There have been improvements
observed in disclosure practices since the introduction of SOX, but these improvements have
come with a cost. Some estimates have put the cost of SOX compliance at $6 billion per year.
This is significant, but in assessing this cost, it is also important to consider the benefits. The
major benefit that results from legislation like SOX is the potential reduction of market failures.
When scandals such as the one at Enron occur, the loss is borne not only by shareholders
but also by employees, other companies, and the general public, who will feel the effect of
2.5. Challenges and Opportunities in Financial Reporting 23
any recession or economic slowing that results from reduced confidence in the markets. But
although the nature of the benefit is clear, the quantification of it is not. It is very difficult to
measure the reduction of market failures that has occurred due to legislation, because if the
legislation worked, there would be nothing to measure.
It would be unrealistic to suggest that regulation could completely eliminate any problem as
complex as information asymmetry. Although SOX did appear to be effective in improving
financial practices and disclosures, it did not prevent the 2008 financial crisis and subsequent
market meltdown. This is likely because the causes of this crisis were not primarily mat-
ters of accounting and reporting – rather, they were related to the regulation and practices
of the investment-banking industry. So the argument can be made that further regulations
are required. But the regulator faces the challenge to determine the appropriate amount of
regulation. Too little regulation can allow fraudulent practices to continue, but too much can
stifle business initiative and growth.
One response by the accounting profession to the need for the further regulation has been the
development of IFRS. These standards were introduced at the time that financial crises were
shaking the financial world in the early 2000s. IFRS are viewed as being more principles
based relative to other standards, such as the United States’ Generally Accepted Accounting
Principles (GAAP), which has historically been more rules based. Principles-based standards
present a series of basic concepts that can be used by professional accountants to make
decisions about the appropriate accounting treatment of individual transactions. These con-
cepts are often intentionally broad and often do not provide specific, detailed guidance to the
accountant. Rules-based standards, on the other hand, are more prescriptive and detailed.
These standards attempt to create a rule for any situation that may be encountered by the
accountant. Accordingly, the body of knowledge is much larger, with much more specific detail
regarding accounting treatments.
Principles-based standards are usually considered to have the advantage of being more flexi-
ble, as they allow for more interpretation and judgment by the accountant. This can be partic-
ularly useful when unusual or unique business transactions are presented to the accountant.
However, this flexibility is one of the weaknesses of this approach. Some fear that giving too
much freedom to the accountant to interpret the accounting standards may result in financial
statements that are less comparable to those of other entities or that could be subject to
increased earnings management or other manipulations.
Because rules-based systems have far greater detailed guidance, some have argued that
this is better for the accountant, as the accountant can defend the treatment of a particular
transaction by simply pointing to compliance with the rule. As well, it is thought that rules-based
systems can also lead to greater comparability, as much of the format and content of disclosure
are tightly prescribed. Unfortunately, overly detailed rules can still allow for a different type
of misrepresentation called financial engineering. When an accounting treatment relies on
specific and detailed rules, creative managers can simply invent a new type of transaction that
works around the existing rules. They will argue that the rule does not specifically prohibit
them from doing what they are doing, but the engineered transaction may, in fact, be violating
24 Why Accounting?
the spirit of the rule. Interpretations that focus more on the form of the transaction than on
the substance can lead to inappropriate and ultimately misleading accounting. As a practical
matter, all systems of accounting regulation contain both broadly based principles and detailed
rules. The challenge for accounting standard setters is to find the right balance of rules and
principles.
It should be apparent that many of the problems faced by the accounting profession stem
from the questionable application of ethical principles. As noted before, the broad purpose
of accounting information is to reduce information asymmetry. Information asymmetry can
never be eliminated, but if accountants can communicate sufficient, useful information, then
the asymmetry can be mitigated. Although it is a normal business practice to try to take
advantage of an information imbalance, if this is done in a misleading or deceitful way that
unfairly disadvantages certain parties, confidence in capital markets will be damaged. The
accountant, in trying to provide as much information as possible to clients, will face pressure
from those vested interests that stand to gain from the information imbalance. The accountant
may be asked to withhold or distort the information to achieve certain results. Often, these
pressures are subtle and not presented as a clear-cut violation of accounting standards.
Business transactions can be complex, and the application of accounting standards to those
transactions can involve significant judgment, estimation, and uncertainty. The answer to an
accounting question may not be clear, and certain interested parties may view this state as an
opportunity to try to influence the accountant.
The management of a company often has a particular interest in trying to influence financial
reports. Managers are given the task by the shareholders of managing the business in the
most efficient and profitable way possible. Managers face great pressures in the task and will
at times look at the financial reporting as one tool to be used to deal with these pressures.
Managers may be motivated to influence or bias the reported financial results for a number of
reasons, including the following:
• The presence of performance-based compensation: Managers may be rewarded in

bonuses or stock options that are directly or indirectly influenced by financial results.
The manager clearly has an incentive to make the results look positive.
• Evaluation of management stewardship: Even if the manager is not directly compen-
sated based on results, the manager’s value to the company will still be evaluated relative
to the business’s performance.
• Meeting market expectations: Financial markets expect results and can be very punitive
when expected results are not achieved. In order to meet the market’s expectations with
respect to performance, the manager may feel pressure to “work the numbers.”
• Conditions of contracts: Some contracts, such as a loan agreement with a bank, may
stipulate that certain financial ratios be maintained. If the ratios are not maintained,
then some punitive consequence will likely be applied, such as a penalty or additional
interest charges. As the financial ratio is based on reported results, the manager has an
incentive to ensure the results keep the company onside.
2.5. Challenges and Opportunities in Financial Reporting 25
• Political pressures: Sometimes a company may face pressures that are not directly
related to the interests of the investors or lenders. A large, profitable company that
enjoys a certain level of oligopolistic power may face additional public scrutiny if profits
are too high. Public-interest groups may feel that the company is taking advantage of
its position of power, and they may demand political action, such as increased taxes or
other sanctions against the company. In order to avoid this type of political heat, the
managers may have an incentive to deliberately reduce or smooth income.
In these examples, it should be apparent that the accountant could play a key role in the
achievement of management’s objectives. The accountant must therefore always be aware
of these motivations and apply sound judgment and ethical principles. But the application
of ethics is not simply a matter of consulting an ethics handbook. An ethical sense is a
personal characteristic that is inherent in each individual. It is very difficult to teach, as
our personal ethics are formed long before we choose to become professional accountants.
Ethical awareness and practice, however, is something for which the accounting profession
has developed a significant framework.
All professional bodies contain codes of conduct for their members. In these codes, basic
principles of ethical behaviour and discussions of how to deal with ethical conflicts are in-
cluded. Some of the common principles that are included in these codes include the following:
• Integrity: The accountant should always act in an honest fashion and not be associated
with any information that is false or misleading.
• Objectivity: The accountant should always be unbiased when applying judgment.
• Professional competence: The accountant should always maintain a level of professional

knowledge that is current and sufficient for performing professional duties and should not
engage in any work that is outside the scope of that accountant’s knowledge.
• Confidentiality: The accountant must not share privileged client information with other
parties and must not use that information for his or her own personal gain.
• Professional behaviour: The accountant should not engage in any activity that discredits
the profession.
Dealing with ethical conflicts and external pressures from stakeholders can be difficult at
times, and accountants are often advised to seek advice from other professionals or their own
professional association when the need arises. Accountants play a key role in the operation of
capital markets and are essential to the financing of a business. The external stakeholders of
the business expect ethical and professional conduct from the accountants, and it is important
the profession continues to earn and maintain this trust.
26 Why Accounting?
Another area which provides both challenges and opportunities to professional accountants
is the increasing use of information technology to perform accounting and reporting func-
tions. Technology has allowed for the automation of routine bookkeeping tasks, as well as
the development more advanced functions such as data mining and strategic analysis. The
increased use of cloud computing and mobile devices has provided platforms for instant
access to information, which could enhance the qualitative characteristic of timeliness. So-
phisticated big data applications could improve the relevance of accounting information by
targeting the specific needs of the user. Technologies such as eXtensible Business Reporting
Language (XBRL) have been designed to improve the comparability of information by providing
a standardized platform for financial statement delivery. Computer assisted audit tools and
techniques allow auditors to more precisely identify key areas of audit risk and to analyze
larger sample sizes, which could lead to improvements in the reliability of information and
the efficiency of the process. The emergence of blockchain technology may provide the
biggest challenge and opportunity to the auditing profession. This type of decentralized,
public ledger has the potential to allow for instant access and verification of transactions.
Smart contract technology could use blockchain to automate and control many accounting
and business processes. As blockchain has the potential to create unalterable, transparent
accounting records, auditors will need to rethink the traditional, annual financial statement
audit. Continuous auditing and verification of the structure of smart contracts may become the
new role for audit professionals.
Recently, the growth of data analytics has begun to change the job of the accountant, and
will likely continue to promote a profound alteration of the accounting and finance fields. The
automation of routine and tedious tasks is only the beginning of the transformation of the
role of financial professionals. Data analytics can be used to add value to an organization
through descriptive, diagnostic, predictive, or prescriptive functions. The accountant of the
future will need to be able to understand how to use both structured and unstructured data
to solve business problems. Although accountants may not be experts in data analysis, they
can provide valuable input and interpretation of the information created by data scientists.
The accountant will need to work collaboratively with data scientists to ensure that the right
questions are being asked, and the results are being deciphered in a meaningful way. Taking
the results of data analysis and communicating them through data visualization techniques will
provide value to the users of financial information.
Although technology provides professional accountants with opportunities to improve the value
of the information provided, it also poses challenges. XBRL has experienced problems with
data-tagging errors, which has reduced its effectiveness. Cloud computing and mobile devices
have increased concerns about data security and economic disruption. Data mining strategies
have led to ethical questions about the privacy of personal information. Real-time reporting of
financial results faces concerns about data reliability, and more significantly, the alteration of
manager behaviour (i.e., earnings management). Professional accountants need to be aware
of these challenges as they adapt to rapidly changing technologies that have the potential to
both benefit and damage the reputation of the profession.
2.6. Conclusion 27
2.6 Conclusion
The accounting profession has seen tremendous transformation over the last forty years,
brought about by changes in technology, the sophistication of capital markets, the business
environment, and business practices. The profession has responded well to many of these
changes, but it needs to continue to seek ways to maintain and improve its own relevance. At
no time in history has so much information been so easily available to so many people. But
how can people be assured that the information is both true and relevant? The accounting
profession – if it is forward looking and responsive – has the ability to provide this assurance
to information users, which will enhance the perceived value of accountants. There are many
challenges to be faced by the profession, and some of these challenges will require solid
research and reasoning and delicate political and negotiation skills. Because accounting is
not a natural science, there are no “right” or “wrong” answers, but as long as the profession
can come up with the “best” answers, it will continue to demonstrate its value.
2.7 IFRS/ASPE Key Differences
Part II of the CPA Canada Handbook does not specifically refer to a conceptual framework.
However, Section 1000–Financial Statement Concepts contains many of the same principles
as identified in the IASB Conceptual Framework. Some of the key differences are identified
below:
28 Why Accounting?
IFRS ASPE
Two fundamental, qualitative characteris- Four principal qualitative characteristics are
tics are relevance and faithful representa- relevance, reliability, comparability, and un-
tion. Comparability and understandability derstandability.
are considered enhancing qualitative char-
acteristics.
Timeliness is considered an enhancing qual- Timeliness is included as a sub-element of
itative characteristic. relevance.
Verifiability is considered an enhancing qual- Verifiability is a sub-element of reliability.
itative characteristic.
Faithful representation includes complete- Reliability includes representational faithful-
ness, neutrality, and freedom from error. ness, verifiability, neutrality, and conser-
vatism. Prudence is a concept that supports
neutrality.
Gains are included in the element “income,” Gains and losses are identified as separate
and losses are included in the element elements of financial statements.
“expenses.”
Three types of capital maintenance con- Only a monetary measure of capital mainte-
cepts are identified, but no prescribed or nance should be used, with no adjustment
preferred approach is indicated. for changes in purchasing power.
Chapter Summary 29
Chapter Summary
LO 1: Identify the purpose of financial reporting.
The purpose of financial reporting is to provide information that is useful for making decisions
about providing resources to the business. The primary user groups are identified as present
and potential investors, lenders, and other creditors, although other users will also find financial
information useful for their purposes.
LO 2: Describe the problem of information asymmetry, and discuss how this

problem can affect the production of financial information.
Information asymmetry simply means there is an imbalance of information between two parties
in a business transaction. This imbalance can create problems in two forms: adverse selection
and moral hazard. Adverse selection means that one party may try to gain a benefit over the
other party by exploiting the information advantage. An example of this behaviour is insider
trading. If insider trading is perceived by the market as being a pervasive problem, investors
may lose confidence in the market, and security prices will drop. The accounting profession
can alleviate this problem by increasing the amount of relevant and reliable information dis-
closed to the market, thus reducing the information advantage of insiders. Moral hazard occurs
when managers shirk their duties because they know their efforts cannot be directly observed.
In order to cover up shirking, managers may bias the presentation of financial results. The
accounting profession can help alleviate this problem by ensuring financial-reporting standards
create disclosures that are useful in evaluating management performance and are not easily
manipulated by management.
LO 3: Describe how accounting standards are set in Canada, and identify the key
entities that are responsible for setting standards.
Currently, accounting standards are set by the Accounting Standards Board (AcSB). This
board applies two sets of standards: International Financial Reporting Standards (IFRS) and
Accounting Standards for Private Enterprise (ASPE). IFRS are required for all publicly ac-
countable entities, while private entities have the choice to use ASPE or IFRS. IFRS are
developed by the International Accounting Standards Board (IASB) and then adopted by the
AcSB. However, the AcSB can remove or alter certain sections of IFRS if it is believed that the
accounting treatment does not reflect Canadian practice.
30 Why Accounting?
LO 4: Discuss the purpose of the conceptual framework, and identify the key
components of the framework.
The conceptual framework provides a solid, theoretical foundation for standard setters when
they have to develop new standards to respond to changes in the business environment. It
also gives practicing accountants a basis and reference point to use when encountering new
or unique business transactions. The key components of the framework describe the purpose
of financial reporting, identify the qualitative characteristics of good accounting information
and the elements of financial statements, and discuss the criteria for recognizing an item in
financial statements, different possible measurement bases, and the framework’s approach to
capital maintenance.
LO 5: Describe the qualitative characteristics of accounting information.
The fundamental characteristics of accounting information are relevance (which is composed

of both predictive and confirmatory characteristics) and faithful representation (which is com-
posed of freedom from error, neutrality, and completeness). Relevance will also be affected by
the concepts of materiality and the nature of the item. Enhancing qualitative characteristics are
understandability, comparability, verifiability, and timeliness. Trying to meet the requirements
of all the characteristics can sometimes result in trade-offs, and this must always be evaluated
in the context of costs compared with potential benefits.
LO 6: Identify the elements of financial statements.
The elements of financial statements are assets, liabilities, equity, income, and expenses.
The definition of each element contains references to the relationships between events and
their time of occurrence, and each definition broadly describes the nature of the element. An
underlying assumption in the preparation of financial statements is that the entity will continue
as a going concern.
LO 7: Discuss the criteria required for recognizing an element in financial

statements.
An element will be recognized in financial statements when it meets the definition of that
element and can be measured reliably, and when it is probable that the future economic
benefits attached to the element will flow to or from the entity.
Chapter Summary 31
LO 8: Identify different measurement bases that could be used, and discuss the
strengths and weaknesses of each base.
The conceptual framework identifies four possible measurement bases: historical cost, current
cost, realizable value, and present value. Historical cost forms the basis of much of current
accounting practice, but other bases are used in circumstances where it is deemed appropri-
ate. Each measurement base has certain advantages and disadvantages, and the choice of
measurement base will often result in a trade-off in decision usefulness.
LO 9: Identify the alternative models of capital maintenance that could be applied.
The conceptual framework identifies three possible capital-maintenance models: monetary

interpretation, constant purchasing power, and physical capital maintenance. Each model
has certain advantages and disadvantages. Current accounting practice is built around the
concept of monetary capital maintenance, but the conceptual framework does not identify one
model as being preferred over the others.
LO 10: Discuss the relative strengths and weaknesses of rules-based and

principles-based accounting systems.
Rules-based systems are seen as providing more detailed guidance to accountants, which
could help accountants defend their work if challenged. As well, rules-based systems are
thought to provide better comparability, as more consistent presentations will result. However,
rules-based systems can also result in financial engineering, where transactions are designed
specifically to circumvent the rules. Principles-based systems are seen as more flexible and
more adaptive to new or unique circumstances. As well, principles-based systems can result
in presentations that better reflect local or industry practices. Principles-based systems are
criticized for being too flexible and allowing for too much judgment by the accountant. This
could create the potential for management influence on the accountant’s work.
LO 11: Discuss the possible motivations for management bias of financial

information.
Management may be tempted to bias or otherwise influence the presentation of financial

information because of compensation contracts that are based on financial results. As well, the
manager will be concerned about meeting investor or analyst targets, meeting the conditions of
loan covenants or other external agreements, achieving certain political or strategic objectives,
32 Why Accounting?
and demonstrating sound stewardship over the company’s assets. All of these motivations pro-
vide a temptation to the manager to influence the results reported in the financial statements.
LO 12: Discuss the need for ethical behaviour by accountants, and identify the key
elements of the codes of conduct of the accounting profession.
As accountants control the preparation and presentation of financial information, they play a
key role in determining the integrity of the information. Accountants will face pressures from
management and other parties who may have an interest in the content and form of financial
disclosures. Thus, accountants, need to practice their craft with an ethical mindset, but they
must also have training in how to deal with ethical issues. All accounting bodies have codes
of professional conduct that provide guidance to suggest that accountants always act with
integrity, objectivity, and competence. As well, these codes usually specify that accountants
should always maintain confidentiality and act in a professional manner. Accountants will often
have to apply significant good judgment when dealing with ethical conflicts.
LO 13: Identify the effects on the accounting profession of changes in information

technology.
Information technology has the potential to improve the relevance, reliability, timeliness, and
comparability of information presented. It can allow accountants and auditors to provide more
useful information and to more accurately identify risks. However, accountants also need to be
aware that these technologies need to be managed carefully to minimize problems that could
negatively affect the quality of information provided.
References
CPA Canada. (2016). CPA Canada Handbook. Toronto, ON: CPA Canada.
International Accounting Standards Board. (2012). Objective, usefulness and limitations of

general purpose. Conceptual Framework for Financial Reporting, OB2. London: IFRS.
Orol, R. D. (2009, April 2). FASB approves more mark-to-market flexibility. Marketwatch.
Retrieved from http://www.marketwatch.com/story/fasb-approves-more-mark-market
-flexibility
Exercises 33
Exercises
EXERCISE 2–1
Describe the problem of information asymmetry and discuss the impact this problem has on
the work of accountants.
EXERCISE 2–2
Discuss the reasons why Canada applies two different sets of accounting standards to profit-
oriented companies. What are the benefits of having two sets of standards? What are the
problems of maintaining two sets of standards?
EXERCISE 2–3
What is the conceptual framework? Why does the accounting profession need this framework?
EXERCISE 2–4
Describe the two fundamental qualitative characteristics of good accounting information. What
problems do accountants face in trying to maximize these characteristics when producing
accounting information?
EXERCISE 2–5
Describe the four enhancing qualitative characteristics and identify conflicts where possible
trade-offs may occur in trying to maximize these characteristics.
EXERCISE 2–6
Identify which of the five financial statement elements applies to each item described below:
a. A cash dividend is declared and paid to the shareholders.
b. Cash is used to purchase a machine that will be used in the production process over the
next five years.
c. Products are sold to customers on 30-days’ credit

34 Why Accounting?
d. Income taxes are calculated based on a company’s profit. The taxes will be paid next
year.
e. A customer makes a deposit on a special order that will not be manufactured until next
year.
f. A bill for electricity used in the current month is received but not payable until the following
month.
g. A shareholder invests money in a business in exchange for issued shares.
h. A shareholder invests money in a business by making a loan with commercial terms to

the business.
i. An insurance settlement is received for a fully depreciated asset that was destroyed in a
fire.
j. An allowance for doubtful accounts is established based on estimates of future uncol-

lectible accounts.
EXERCISE 2–7
Consider the following independent situations. For each of the situations described, discuss
how the recognition criteria should be applied and suggest the appropriate accounting treat-
ment.
a. A publisher sells magazines on a two-year subscription. Customers are required to pay

the full amount at the commencement of the subscription.
b. A company is being sued by a customer group for losses sustained due to a faulty
product design. The company’s lawyers feel the suit will likely succeed, but they cannot
estimate the potential amount of damages that will be awarded.
c. A company has completed a large infrastructure construction project as part of an eco-

nomic development partnership with a foreign government. The invoice for the work
has been issued, but due to a recent change in government, there is some doubt about
whether payment will actually be received.
d. A social media company has recorded an asset described as ”Goodwill” and an offsetting
amount in its equity section. The amount was determined by comparing the current
trading value of the company’s shares to the recorded value of the company’s shares on
the balance sheet.
e. A resource company is obligated by municipal regulations to clean up the site of an

active drilling operation in 10 years’ time when the resource has been fully extracted.
The company is in its first year of operations and has no previous experience in cleaning
up drilling sites.
Exercises 35
EXERCISE 2–8
Describe the four different measurement bases and discuss the relative strengths and weak-
nesses of each base.
EXERCISE 2–9
What are some of the difficulties in trying to determine the best concept of capital maintenance
to apply to the development of accounting standards?
EXERCISE 2–10
Discuss the relative merits and weaknesses of principles-based and rules-based accounting
systems.
EXERCISE 2–11
What are some of the motivations that managers may have for attempting to influence or bias
reported financial results? What should the accountant do to deal with these possible attempts
to affect the perceptions of the company’s results?
EXERCISE 2–12
You have just been appointed financial controller at Dril-Tex Inc., a manufacturer of specialized
equipment used by various manufacturers of consumer products on their own production lines.
Your immediate supervisor, the vice-president finance, has indicated that he will be retiring
in six months and that you could be in line for his position if you do a good job managing
the preparation of the year-end financial statements. He has provided you with the following
comments for your consideration during the preparation of these statements:
a. The company is currently being sued for breach-of-contract by one of our largest cus-
tomers. This case has been ongoing for two years and will likely reach a conclusion next
year. Our lawyers have now estimated that it is likely we will lose, and that the award will
probably be in the range of $250,000 to $300,000. We have disclosed this previously in
our notes, but have not accrued anything. Use the same treatment this year, as the case
is not yet completed.
b. We have changed our inventory costing method this year from weighted-average to
36 Why Accounting?
FIFO. This has resulted in an increase in net income of $115,000. The new method
should be identified in the accounting policy note.
c. There are $50,000 worth of customer prepayments included in the Accounts Receivable
sub-ledger. The customers have paid these amounts to guarantee their priority in our
production cycle, but no work has yet been done on their special orders. We will just
net these prepayments against the Accounts Receivable balance and report a single
amount on the balance sheet.
d. This year we hired a director of research and development. He has not yet produced
any viable products or processes, but he was a top performer at his previous company.
We have capitalized the cost of his salary and benefits, as we are confident he will soon
be producing a breakthrough product for us.
e. Our bank has put us on warning that our current ratio and debt-to-equity ratio are close
to violation of the covenant conditions in our loan agreement. Violations will likely result
in an increase in the interest rate the bank charges us. Keep this in mind as you prepare
the year-end adjustments.
Comment on the accounting treatments proposed by the vice-president finance, supporting

your discussion with any relevant components from the conceptual framework. Discuss the
impact of item (e) on your work in preparing the year-end financial statements.
Chapter 3
Financial Reports: Statement of Income, Compre-
hensive Income and Changes in Equity
Material Weaknesses Found in Financial Reporting Oversight
In 2014, Penn West Petroleum Ltd., a Calgary-based oil company, was tasked with restat-
ing more than two years of financial statements in response to an internal investigation
that uncovered material weaknesses in its internal controls over financial reporting. The
impact of the restatement was a reduction in cash flow by $145 million and an increase in
its operating costs by $367 million–no small sums, to be sure!
The investigation was undertaken after the discovery of misclassifications in its accounting
records regarding its capital spending, operating costs, and royalty payments. The investi-
gation found that operating expenses were recorded to property, plant, and equipment,
and significant amounts of operational expenses were reclassified to royalties’ assets.
The company claimed that these errors originated with some former employees who were
no longer with the company. When news of the scandal reached investors’ ears, fears
escalated, resulting in large numbers of shares being sold off in the stock market. In
the aftermath, investors launched $400 million in class-action lawsuits in Canada and the
U.S., alleging that the company and some of its former top executives were negligent in
not ensuring that adequate internal controls regarding financial reporting were in place.
It is unknown whether the misclassifications were due to management bias, intended to

deceive, or if they were due to human error and poor judgment. Either way, the financials
prior to restatement were making the company look better than it was.
Penn West implemented new internal controls to ensure that this never happens again.
A key component of the change relates to its journal entries, to ensure any transactions
that are to be capitalized (versus being expensed) are done so only after passing a strict
oversight process.
(Source: Jones, 2014)
LO 1: Describe the statement of income, the statement of comprehensive income, and the
statement of changes in equity and their roles in accounting and business.
37
38 Financial Reports: Statement of Income, Comprehensive Income and Changes in Equity
LO 2: Identify the factors that influence what is reported in the statement of income, state-
ment of comprehensive income, and the statement of changes in equity.
LO 2.1: Explain the factors that influence the choice of accounting year-end.
LO 2.2: Explain how changes in accounting estimates, changes due to correction of
accounting errors, and changes in accounting policy affect the income and equity
statements.
LO 3: Identify the core financial statements and explain how they interconnect together.
LO 3.1: Explain the differences between IFRS and ASPE regarding the income and eq-
uity statements.
LO 4: Describe the various formats used for the statement of income and the statement of
comprehensive income, and identify the various reporting requirements for companies
following IFRS and ASPE.
LO 5: Describe the various formats used to report the changes in equity for IFRS and ASPE
companies, and identify the reporting requirements.
LO 6: Identify and describe the techniques used to analyze income and equity statements.
Introduction
Financial reports are the final product of a company’s accounting processes. These reports,
combined with thoughtful analysis, are intended to “tell the story” about the company’s op-
erations, its financial performance for the reporting period, and its current financial state
(resources and obligations) including its cash position for that period. Is it good news or
bad news for management, investors, and creditors who are the company’s stakeholders?
Did the company meet its financial goals and objectives for the fiscal year? The answers
depend not only on the outcome of the actual operations reported in the financial statements,
but also on their accuracy and reliability, as the opening story about Penn West explained.
As discussed in Chapter 2, financial statements consist of a set of core reports that identify
the company’s resources (assets), claims to those resources (liabilities and investor’s equity),
and information about the changes in these resources and claims (performance). A key activity
after the financial statements are prepared is to accurately analyze and evaluate the company’s
performance and determine if it met its objectives for the reporting period. This chapter will
discuss financial statements that report net income, comprehensive income, and changes in
equity and their ability to tell the story about the company’s performance for the reporting
period.
1.0 Financial
Reporting: Overview
Accounting Year-End
2.0 Factors that Influence
Financial Reports Changes in Accounting
Estimates, Policy, and
Correction of Errors
3.0 Financial Statements, Differences Between

Interrelationships IFRS and ASPE
Financial Reports:
Statement of Income, 4.0 Statement of Income Statement Formats and
Comprehensive and Comprehensive Income Reporting Requirements
Income and
Changes in Equity
5.0 Statement of Changes in
Statement Formats and
Equity(IFRS) and Statement
Reporting Requirements
of Retained Earnings(ASPE)
6.0 Analysis of Income

Types of Analysis and
and Statement of
Segmented Reporting
Changes in Equity
7.0 IFRS and ASPE

Applicable Standards
3.1 Financial Reporting: Overview
The accounting system is a data repository that tracks all the economic events that have
occurred during an accounting cycle (period) and reports them in some meaningful way to
the company stakeholders. For example, the statement of income is a report required by
both IFRS and ASPE that measures the return on capital (assets) – it is the “how well did we
do” statement. This statement shows how the company performed during its operations for a
specific period of time (typically annually, monthly, or quarterly). Key elements of the income
statement include various revenue, expenses, gains, and losses for continuing and discontin-
ued operations. Combined, these numbers represent the company’s net income or loss (profit
or loss) for the reporting period. Comprehensive income (an IFRS-only requirement) begins
with net income and reports certain gains and losses not reported in net income such as those
arising from fair value re-measurements for certain investments. The statement of changes in
equity identifies details about the changes in equity due to transactions affecting shareholders
as owners and investors of the company.
The IFRS and ASPE accounting standards describe which financial data is to be specifically
identified and reported, out of the many thousands of transactions making up the accounting
records. To comply with these standards, separate reporting of certain information either within
the body of the financial statements or within the notes to the financial statements is required.
That said, there is some flexibility regarding the information to be reported. For example, the
terminology and the style used to present the data within the financial statements are often left
to management’s discretion.
This chapter will discuss preparation of these core financial statements, identify the mandatory
reporting requirements, and look at how these statements can be analyzed to assist in decision
making by management, investors, and other stakeholders.
3.2 Factors that Influence Financial Reports
3.2.1 Accounting Year-end
Choosing the fiscal year-end date is a strategic activity that requires careful consideration
because the decision made can result in operational and tax advantages. The year-end will
likely be influenced most by the company’s business cycle. For example, a retailer will likely
choose a year-end at the end of its busiest season, when inventory is at its lowest levels. This
makes the physical count easier and less costly, because there will be more staff available and
fewer adjustments to make before the books are closed. Planning a fiscal year-end based on
advantageous tax consequences can be tricky, but essentially it means choosing a year-end
that results in some temporary differences between certain transactions accounted for in one
fiscal year but not taxed until a subsequent fiscal year. Alternatively, businesses that are not
incorporated (e.g., proprietorships and partnerships) may choose the calendar year-end to
coincide with Canada Revenue Agency, for simplicity from a tax perspective. Whatever fiscal
year-end is chosen, accounting standards require that the financial statements be accrual
based. This relates back to the accounting principles of revenue recognition, in terms of
when to record revenue, and the matching principle, to ensure that all expenses related to
that revenue recorded are included. The statements are also the results of operations for a
specified period of time (the periodicity principle), called the reporting period. This raises
the issues of what, when, and how much detail to record for any transactions that occur near,
at, or subsequent to the reporting period year-end date.
Financial statements are often done on an interim basis each year. Interim reports can
be monthly, quarterly, or some other reporting period. For example, public companies in
Canada are required to produce quarterly financial statements. The accounting cycle has
3.2. Factors that Influence Financial Reports 41
not yet been completed, so the temporary revenue, expense, gains, and loss accounts are
not closed, and several end-of-period adjusting entries are recorded in order to ensure that
the accounting records are as complete as possible for the interim period being reported.
The annual published financial statements usually cover a fiscal or calendar year (on rare
occasions, an operating cycle, if longer than one year). After the release of the year-end
financial statement, the temporary accounts are closed to retained earnings, and an updated
post-closing trial balance for all the (permanent) balance sheet accounts is completed to
commence the new fiscal year.
There is also a period of time after the year-end date when certain events or transactions
detected in the new fiscal year may need to either be recorded and reported in the financial
statements or disclosed in the notes to the financial statements. For this reason, the account-
ing records from the previous fiscal year are kept open to accrue any significant entries and
adjustments found in the new year that pertain to the fiscal year just ended. This time period
may be anywhere from a few days to several weeks or months, depending on the size of the
company. The end of this time marks the point at which the temporary accounts for the old
fiscal year are closed and the financial statements are completed and officially published.
The following are examples of these types of transactions.
• Inventory – the physical inventory count that takes place as soon after the year-end
date as possible. The total amount from the physical count is compared to the ending
balance in the inventory subledgers, and an adjusting entry recorded for the difference.
Since the accounting standards state that inventory is to be valuated each reporting date
at the lower of cost and net realizable value (LCNRV), a write-down of inventory due to
shrinkage may be required.
• Invoices Received after Year-end – this relates to goods and services received from
suppliers before the year-end date, but not yet recorded. For example, companies
purchasing goods from a supplier close to the year-end date usually receive the goods
with a packing slip that details the types and quantities of goods received as well as the
total cost. Once the goods are received and verified, the entry to record the goods and
recognize the accounts payable will occur with the packing slip and the company’s own
purchase order being the source documents for the accounting entry. Recording entries
relating to purchasing services, on the other hand, can be tricky since there is no packing
slip involved when purchasing services. If the supplier providing the services does not
leave an invoice with the purchaser as soon as the services have been completed, it will
be sent at some later date, usually sometime during the following month of the new fiscal
year. Keeping the books open for a time after the year-end date allows the company extra
time to catch and record any significant transactions that are discovered during the next
fiscal year that might otherwise be missed.
Any significant subsequent event that occurs after the fiscal year-end should be disclosed in
the notes to the financial statements for the year just ended. An example might be where early
in 2021 vandals damage some buildings and equipment. If the repair or replacement costs
are material, these costs, though correctly paid and recorded in 2021, should be disclosed
in the financial statements of 2020 if not yet published. This will ensure that the company
stakeholders have access to all the relevant information.
3.2.2 Changes in Accounting Estimates, Changes in Accounting Policy, and

Correction of Errors
Financial statements can be impacted by changes in accounting policies, changes in esti-

mates, and correction of errors. These were first introduced in the introductory accounting
course and will also be discussed in detail in the next intermediate accounting course. How-
ever, it is worth including a review at this time because they can significantly affect the financial
statements.
Changes in Accounting Estimates
Accounting is full of estimates that are based on the best information available at the time. As
new information becomes available, estimates may need to be changed. Examples of chang-
ing estimates would be changing the useful life, residual value, or the depreciation method
used to match use of the assets with revenues earned. Other estimates involve uncollectible
receivables, revenue recognition for long-term contracts, asset impairment losses, and pension
expense assumptions. Changes in accounting estimates are applied prospectively, meaning
they are applied to the current fiscal year if the accounting records have not yet been closed
and for all future years going forward.
Changes in Accounting Policy
The accounting treatment for a change in accounting policy is retrospective adjustment with
restatement. Retrospective application means that the company deals with the error or omis-
sion as though it had always been corrected.
Examples of changes in accounting policies are:
• changes in valuation methods for inventory such as changing from FIFO to weighted
average cost
• changes in classification, presentation, and measurement of financial assets and li-

abilities under categories specified in the accounting standards such as investments
classified as fair value reported through net income (FVNI), amortized cost (AC), or fair
value reported through OCI (FVOCI) (IFRS only). Details of these are discussed in the
chapter on intercorporate investments, later in this text.
3.2. Factors that Influence Financial Reports 43
• changes in the basis of measurement of non-current assets such as historical cost and
revaluation basis
• changes in the basis used for accruals in the preparation of financial statements
Management must consistently review its accounting policies to ensure they comply with the
latest pronouncements by IFRS or ASPE and to ensure the most relevant and reliable financial
information for the stakeholders. Accounting policies must also be applied consistently to
promote comparability between financial statements for different accounting periods. For this
reason, a change in accounting policy is only allowed under two conditions:
1. due to changes in a primary source of GAAP
2. applied voluntarily by management to enhance the relevance and reliability of information

contained in the financial statements for IFRS. ASPE has some exceptions to this “rele-
vance and reliability” rule to provide flexibility for changes from one existing accounting
standard to another.
As a rule, changes in accounting policies must be applied retrospectively with restatement to

the financial statements. Retrospective application means that the company implements the
change in accounting policy as though it had always been applied. Consequently, the company
will adjust all comparative amounts presented in the financial statements affected by the
change in accounting policy for each prior period reported. Retrospective application reduces
the risk of changing policies to manage earnings aggressively because the restatement is
made to all prior years as well as to the current year. If this were not the case, the change
made to a single year could materially affect the statement of income for the current fiscal year.
A cumulative amount for the restatement is estimated and adjusted to the opening retained
earnings balance of the current year, net of taxes, in the statement of changes in equity (IFRS)
or the statement of retained earnings (ASPE). This will be discussed and illustrated later in
this chapter.
Retrospective application of a change in accounting policy may be exempted in the following

circumstances.
• A transitional provision of the changed standard allows the prospective application of a

new accounting policy. Specific transitional guidance of IFRS or ASPE must be followed
in such circumstances.
• The application of a new accounting policy regarding events, transactions, and circum-
stances that are substantially different from those that occurred in the past.
• The effect of the retrospective application of a change in accounting policy is immaterial.

• The retrospective application of a change in accounting policy is impracticable. This may

be the case where a company has not collected sufficient data to enable an objective
assessment of the effect of a change in accounting estimates and it would be unfeasible
or impractical to reconstruct the data. Where impracticability impairs a company’s ability
to apply a change in accounting policy retrospectively from the earliest prior period
presented, the new accounting policy must be applied prospectively from the beginning
of the earliest period feasible, which may be the current period.
The following are the required disclosures in the notes to the financial statements when a
change in accounting policy is implemented:
• Title of IFRS or ASPE standard
• Nature of change in accounting policy
• Reasons for change in accounting policy
• Amount of adjustments in current and prior periods presented
• Where retrospective application is impracticable, the conditions that caused the imprac-
ticality (CPA Canada, 2011).
Changes Due to Accounting Errors or Omissions
The accounting treatment for an error or omission is a retrospective adjustment with restate-
ment. For example, an accounting error in inventory originating in the current fiscal year
is detected within the current fiscal year while the accounting records are still open. The
inventory error correction is recorded as soon as possible to the applicable accounts. However,
if the accounting records are already closed when the inventory error is discovered, the error
is treated retrospectively. This means that the cumulative amount due to the inventory error
would be calculated and recorded, net of taxes, to the current year’s opening retained earnings
balance. If the financial statements are comparative and include previous year’s data, this data
is also restated to include the error correction. This will be discussed and illustrated later in
this chapter.
3.3 Financial Statements and Their Interrelationships
The core financial statements connect to complete an overall picture of the company’s opera-
tions and its current financial state. It is important to understand how these reports connect;
therefore, a review of some simplified financial statements for Wellbourn Services Ltd., a large,
3.3. Financial Statements and Their Interrelationships 45
privately-held company is presented below (assume Wellbourn applies IFRS; for simplicity,
comparative year data and reporting disclosures are not shown).
Wellbourn Services Ltd.

Statement of Income
for the year ended December 31, 2020
Revenues:
Sales $ 250,000
Services revenue 53,000
Total revenue $ 303,000
Operating expenses:
Cost of good sold 100,000
Rent expense 23,000
Salaries expense 65,000
Total operating expense 188,000
Income from continuing operations before tax 115,000
Income tax 34,500
Net income $ 80,500
Earnings per share $ 24

Statement of Comprehensive Income
Net income $80,500 to R/E
Other comprehensive income:
Items that may be reclassified subsequently to net income or loss:
Unrealized gains from FVOCI investments
(net of tax of $1,500) 3,500 to AOCI
Total comprehensive income $84,000

Statement of Changes in Equity
Accumulated Other
Common Contributed Retained Comprehensive
Shares Surplus Earnings Income Total
Balance, January 1 $200,000 $25,000 $75,000 $45,000 $345,000
Total comprehensive income:
Net income 80,500 80,500
Other Comprehensive Income 3,500 3,500
Total comprehensive income 80,500 3,500 84,000
Issuance of common shares 10,000 10,000
Dividends declared (50,000) (50,000)
Balance, December 31 $210,000 $25,000 $105,500 $48,500 $389,000

Statement of Financial Position
December 31, 2020
Assets Liabilities
Current assets Current liabilities
Cash $135,500 Accounts payable $ 77,500
Accounts receivable (net) 225,000 Accrued liabilities 225,000
Inventory 130,000 Total current liabilities 302,500
Total current assets 490,500 Bonds payable 160,000
Investments 100,000 Total liabilities 462,500
Property, plant, and equipment (net) 246,000 Equity
Intangible assets 15,000 Common shares 210,000
Total assets $851,500 Contributed surplus 25,000
Retained earnings 105,500
AOCI 48,500
Total equity 389,000
Liabilities and equity $851,500

Statement of Cash Flows
Cash flows from operating activities
Cash received from clients $ 50,000
Cash paid for supplies (25,000)
Cash paid to employees (51,200)
Net cash used by operating activities (26,200)
Cash flows from investing activities
Purchase of equipment (25,000)
Net cash used by investing activities (25,000)
Cash flows from financing activities
Dividends paid (50,000)
Issued bonds 160,000
Net cash received by financing activities 110,000
Net increase in cash 58,800
Cash balance, January 1 76,700
Cash balance, December 31 $ 135,500
As can be seen from the flow of the numbers above, the net income from the statement of
income becomes the opening amount for the statement of comprehensive income (a statement
required for all IFRS reporting companies).
Comprehensive income starts with net income/loss and includes certain gains or losses called
other comprehensive income (OCI) that are not already reported in net income. The most
notable examples for purposes of this course are:
• unrealized gains or losses for investments classified as fair value through OCI (FVOCI),
3.3. Financial Statements and Their Interrelationships 47
resulting from changes in their fair value while the investment is being held (Chapter 8)
• gains/losses resulting from the application of the revaluation method for property, plant
and equipment, and intangibles (Chapter 9)
In the next intermediate accounting course, another OCI item is the remeasurement gains and
losses regarding defined benefit pension plans.
To summarize:
IFRS companies must report:
• Other comprehensive income (OCI) = certain gains or losses not already included in net
income, net of tax, with tax amount disclosed
• Total comprehensive income = net income/loss +/- other comprehensive income (OCI)
Returning to the Wellbourn financial statements, looking at the statement of comprehensive

income, net income closes to retained earnings, while any other comprehensive income (OCI)
gain or loss closes to accumulated other comprehensive income (AOCI) in the statement of
changes in equity. The AOCI account is similar to a retained earnings account, except that
AOCI only accumulates items from OCI.
To summarize:
• Retained earnings accumulate net income/loss over time. (ASPE and IFRS)
• AOCI accumulates other comprehensive income (OCI)/losses over time. (IFRS only)
It should also be noted that IFRS companies can choose to keep the statement of income
separate from the statement of comprehensive income, or they can combine the two state-
ments into one report called the statement of income and comprehensive income, which will
be discussed in more detail in the next section.
Looking at the Wellbourn statement of changes in equity, note that the total column balances to
the equity section of the statement of financial position/balance sheet (SFP/BS). The final link
between all the financial statements is regarding the statement of cash flows (SCF), where
the ending cash balance must be equal to the cash balance reported in the SFP/BS. This
completes the loop of interconnecting accounts and amounts.
3.3.1 Financial Statement Differences Between IFRS and ASPE
The core financial statements shown above illustrate the types of statements required for IFRS
companies. They are the following:
• a statement of income
• a statement of comprehensive income
• a worksheet-style statement of changes in equity with all the equity accounts included
• a statement of financial position
• a statement of cash flows
• notes to the financial statements
IFRS requires the comparative previous year amounts be reported as well as disclosure of the
earnings per share. ASPE does not require these disclosures. IFRS requires the statement
of comprehensive income (or a combined statement of income and comprehensive income),
whereas ASPE only requires a statement of income because comprehensive income does not
exist. The statement of changes in equity required by IFRS shown in the Wellbourn example
above now becomes a more simplified statement of retained earnings for ASPE, where only
the details for retained earnings are reported (though any changes in shareholder equity
accounts must be disclosed in the notes to the financial statements). The remaining equity
accounts such as common shares and contributed surplus are reported as ending balances
directly in the balance sheet for ASPE (called the statement of financial position for IFRS
companies).
3.4 Statement of Income and Comprehensive Income
As previously stated, net income is a measure of return on capital and, hence, of performance.
This means that investors and creditors can often estimate the company’s future earnings and
profitability based on an evaluation of its past performance as reported in net income. Compar-
ing a company’s current performance with its past performance creates trends that can have
a predictive, though not guaranteed, value about future earnings performance. Additionally,
comparing a company’s performance with industry standards helps to assess the risks of not
achieving goals compared to competitor companies in the same industry sector.
As previously mentioned, all the core financial statements are based on accrual accounting.
Accrual accounting, in turn, is based on a series of standards-based processes and estimates.
3.4. Statement of Income and Comprehensive Income 49
Some of these estimates have more measurement uncertainty than others, and some esti-
mates are inherently more conservative than others. This in turn affects the quality of earnings
reported in an income statement.
Quality of earnings – the amount of earnings attributable to sustainable ongoing core business
activities rather than to “artificial profits” arising from:
• differences in earnings due to applying the various accounting policy choices such as
FIFO or weighted average cost for inventory valuation or straight-line, declining-balance,
or units-of-production depreciation methods
• the use of estimates such as those for estimating bad debt or warranty provisions
• the presence of significant amounts of non-operating gains and losses compared to

income from continuing operations
• the inclusion of unreliable items such as inappropriate contingent gains
• management bias and reported amounts not objectively determined
• differences due to IFRS or ASPE application of standards
• information that is not concise or clearly presented and is poorly understood, resulting in
potential misstatement
Lower quality earnings will include significant amounts of the items listed. If the quality of
earnings is low, more risk is associated with the financial statements, and investors and
creditors will place less reliance on them.
Single-step and Multiple-step Statement of Income
Single-step, multiple-step, or any condensed formats used in a statement of income are not
specified GAAP requirements. Companies can choose whichever format best suits their
reporting needs. Smaller privately held companies tend to use the simpler single-step for-
mat, while publicly traded companies tend to use the multiple-step format. When condensed
formats are used, they are supplemented by extensive disclosures in the notes to the financial
statements and cross-referenced to the respective line items in the statement of income.
The Wellbourn Services Ltd. statement of income, shown earlier, is an example of a typical
single-step income statement. For this type of statement, revenue and expenses are each
reported in the two sections for continuing operations. Discontinued operations are separately
reported below the continuing operations. The separate disclosure and format for the discon-
tinued operations section is a reporting requirement and is discussed and illustrated below.
The condensed or single-step formats make the statement simple to complete and keeps
sensitive information out of the hands of competitive companies, but provides little in the way
of analytical detail.
The multiple-step income statement format provides much more detail. Below is an example
of a multiple-step statement of income for Toulon Ltd., an IFRS company, for the year ended
December 31, 2020.
Multiple-step format -
Minimum Line Item
typical sections and
Disclosures:
subtotals: Toulon Ltd.
Consolidated Statement of Income and Comprehensive Income Heading
Heading
In $000’s except per share amounts 2020 2019 Comparative years (IFRS)
Sales $6,260 $5,008 Revenue – separated into major

Gross profit section with categories (IFRS & ASPE)
subtotal Cost of goods sold 2,500 1,750 Inventory charged to expense
Gross profit 3,760 3,258 (IFRS & ASPE)
Operating expenses Employee benefits expense in-

cluding salaries and wages, pay-
Salaries and benefits expense 650 520 roll taxes, health care costs, and
post-retirement benefits (IFRS)
Depreciation expense 35 20 Depreciation and amortization

(IFRS & ASPE)
Travel and entertainment expense 150 120
Operating expenses Advertising expense 55 45
with subtotal
Freight-out expenses 10 8
The remaining expenses by na-
Supplies and postage expense 5 4 ture (IFRS)
Telephone and internet expense 15 12
Legal and professional expenses 8 6
Insurance expense 6 5
934 740
Income from operations 2,826 2,518
Other revenue and expense This section is for non-operating
Dividend revenue 3 3 items. Finance costs such as in-
terest income & expense, foreign
Non-operating section Interest income from investments 2 2 exchange, gain/loss from sale or
with subtotal Gain from sale of trade investments 4 0 impairment of assets and interest
Interest expense (2) (3) (IFRS & ASPE)
7 2
Income from continuing operations 2,833 2,520
before income tax Income tax expense on continuing
Income tax expense Income tax expense 850 680 operations (IFRS & ASPE)
Subtotal from
continuing operations Income from continuing operations 1,983 1,840 Same as Income before discontin-
Discontinued operations ued operations (ASPE)
Loss from operation of discontinued division
(net of tax of $45,000) (105) 0 Discontinued operations, net-of-
Discontinued operations tax with tax amounts disclosed
Loss from disposal of division (IFRS & ASPE)
(net of tax of $18,000) (42) 0
(147) 0
Net income (profit or
Net income (note 1) 1,836 1,840 Net income (profit or loss)
loss)
Other comprehensive income:
Items that may be reclassified subsequently
Comprehensive income to net income or loss: Other comprehensive income by
(IFRS) Unrealized gain from FVOCI investments nature (IFRS)
(net of tax of $6,000 for 2020 and $3,000
for 2019 respectively) 14 9
Total comprehensive income 1,850 1,849 Total comprehensive income sep-
arated into attributable to par-
Non-controlling interests (minority interests) (11) (12)
ent and non-controlling interests
Attributable to the equity holders of Toulon $1,839 $1,837 (IFRS)
Earnings per share, attributable to

the equity holders of Toulon:
Basic EPS from continuing and
Basic earnings per share discontinued operations (IFRS)
Earnings per share Continuing operations $ 16.32 $13.25
Basic and diluted EPS Discontinued operations (1.23) 0
(IFRS)
Diluted earnings per share
Continuing operations 12.86 13.75 Diluted EPS from continuing and
Discontinued operations (1.03) 0 discontinued operations (IFRS)
Note 1: Net income 1,836 1,840 Net income (profit or loss) sepa-
rated into attributable to the par-
Non-controlling interests (minority interests) (10) (11)
ent and non-controlling interests
Attributable to the equity holders of Toulon $ 1,826 $1,829 (IFRS & ASPE)
Other revenue and expenses section is to report non-operating transactions not due to typical
daily business activities. For example, if a company sells retail goods, any interest expense
incurred is a finance cost, and is not due to being in the retail business.
Toulon reported four non-operating items:
• Dividend revenue would be for dividends received from an investment in shares of

another company
• Interest income from investments would likely be from an investment in bonds of another
company
• Gain from the sale of trading investments would be for the profit made when the invest-
ment was sold. In this case, the investment is classified as fair value through net income
(FVNI), which means any changes in the investment’s fair value at each reporting date,
or profit upon sale, are reported as a gain/loss in net income
• Interest expense would be any interest paid on amounts owed to various creditors.
This is considered to be a financing expense and not an operating expense, unless
the company is a finance company.
Other examples of non-operating items are listed below:
• write-down of inventory
• impairment losses and reversals of impairment losses on PPE, intangible assets, and
goodwill
• foreign currency exchange gains or losses
• gain or loss from asset disposal or from long-lived assets reclassified as held for sale
• interest expense by current liabilities, long-term liabilities, and capital lease obligations
• unusual items (not typical and infrequent)
The multiple-step format with its section subtotals makes performance analysis and ratio
calculations such as gross profit margins easier to complete and makes it easier to assess
the company’s future earnings potential. The multiple-step format also enables investors and
creditors to evaluate company performance results from continuing and ongoing operations
having a high predictive value compared to non-operating or unusual items having little pre-
dictive value.
Operating Expenses
Expenses from operations must be reported by their nature and, optionally, by function (IFRS).
Expenses by nature relate to the type of expense or the source of expense such as salaries,
insurance, advertising, travel and entertainment, supplies expense, depreciation and amorti-
zation, and utilities expense, to name a few. The statement for Toulon Ltd. is an example of
reporting expenses by nature. Reporting expenses by nature is mandatory for IFRS compa-
nies; therefore, if the statement of income reports expenses by function, expenses by nature
would also have to be reported either as a breakdown within each function in the statement of
income itself or in the notes to the financial statements.
Expenses by function relate to how various expenses are incurred within the various de-
partments and activities of a company. Expenses by function include activities such as the
following:
• sales and marketing
• production
• office and administration
• research and development
Common costs such as utilities, supplies, insurance, and property tax expenses would have to
be allocated between the various functions using a reasonable basis such as square footage
or each department’s proportional share of overall expenses. This allocation process can be
cumbersome and will require more time, effort, and professional judgement.
The sum of all the revenues, expenses, gains, and losses to this point represents the income
or loss from continuing operations. This is a key component used in performance analysis
and will be discussed later in this chapter.
Income Tax Allocations

Intra-period tax allocation is the process of allocating income tax expense to various cate-
gories within the statement of income, comprehensive income, and retained earnings.
For example, income taxes are to be allocated to the following four categories:
1. Income from continuing operations before taxes
2. Discontinued operations, net of tax
3. Each item reported as other comprehensive income, net of tax
4. Each item regarding retrospective restatement for changes in accounting policy or cor-
rection of prior period errors reported in retained earnings, net of tax, which is also
discussed later in this chapter
The purpose of these allocations is to make the information within the statements more in-
formative and complete. For example, Toulon’s statement of income for the year ending
December 31, 2020, allocates 30% income tax as follows:
• Income from continuing operations of $850,000 ($2,833,000 × 30%)
• Loss from discontinued operations of $45,000 ($150,000 × 30%)
• Loss from disposal of discontinued operations of $18,000 ($60,000 × 30%)
• Comprehensive income gain from FVOCI investments of $6,000 ($20,000 × 30%)
All companies are required to report each of the categories above net of their tax effects. This
makes analyses of operating results within the company itself and of its competitors more
comparable and meaningful.
Note: if there is a net loss, the income tax reported on the income statement will be “income
tax recovery” and shown as a negative (bracketed) amount.
Discontinued operations
Sometimes companies will sell or shut down certain business components or operations be-
cause the operating segment or component is no longer profitable, or they may wish to focus
their resources on other business components. To be separately reportable as a discontinued
operation in the statement of income, the business component being discontinued must have
its own clearly distinguishable operations and cash flows, referred to as a cash-generating
unit (CGU) for IFRS companies. Examples are a major business line or geographical area.
If the discontinued operation has not yet been sold, there must be a formal plan in place to
dispose of the component within one year and to report it as a discontinued operation.
The items reported in this section of the statement of income are to be separated into two
reporting lines:
• Gains or losses in operations prior to disposal of the CGU, net of tax, with tax amount
disclosed
• Gains or losses in operations on disposal of the CGU, net of tax, with the tax amounts
disclosed
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Net Income and Comprehensive Income
Note that the statement for Toulon Ltd. combines net income and total comprehensive income.
Two statements would be prepared for IFRS companies that prefer to separate net income from
comprehensive income. The statement of income, ends at net income (highlighted in yellow).
A second statement, called the statement of comprehensive income, would start with net
income and include any other comprehensive income (OCI) items. The Wellbourn financial
statement (shown in section 3.3 of this chapter) is an example of separating net income and
total comprehensive income into two statements.
Another item that is important to disclose in the financial statements is the non-controlling
interest (NCI) reported for net income and total comprehensive income. This is the portion
of equity ownership in an associate (subsidiary) that is not attributable to the parent company
(Toulon, in our example) that has a controlling interest (greater than 50% but less than 100%
ownership) in the acquired company’s net assets. Toulon must consolidate the associate’s
financial data with its own and report as a single entity to comply with IFRS standards. Con-
sider that if a company purchases 80% of the net assets of another company, the remaining
20% must therefore be owned by outside investors. This 20% amount must be reported as
the non-controlling interest to ensure that investors and creditors of the company holding 80%
(parent) are adequately informed about the true value of the net assets owned by the parent
company versus outside investors.
For ASPE companies using a multiple-step format, the statement of income would look virtually
the same as the example for Toulon above and would include all the line items up to the net
income amount (highlighted in yellow). As previously stated, comprehensive income is an
IFRS concept only; it is not applicable to ASPE.
Earnings per Share

Basic earnings per share represent the amount of income attributable to each outstanding
common share, as shown in the calculation below:
Net income − preferred dividends

Basic earnings per share (EPS) =
Weighted average number of
common shares outstanding
The earnings per share amounts are not required for ASPE companies. This is because
ownership of privately owned companies is often held by only a few investors, compared to
publicly-traded IFRS companies where shares are held by many investors.
For IFRS companies, basic earnings per share excludes OCI and any non-controlling interests.
EPS is to be reported on the face of the statement of income as follows:
• Basic and diluted EPS from continuing operations
• Basic and diluted EPS from discontinued operations, if any
The term basic earnings per share refers to IFRS companies with a simple capital structure
consisting of common shares and perhaps non-convertible preferred shares or non-convertible
bonds. Reporting diluted earnings per share is required when companies hold financial instru-
ments such as options or warrants, convertible bonds, or convertible preferred shares, where
the holders of these instruments can convert them into common shares at a future date. The
impact of these types of financial instruments is the potential future dilution of common shares
and the effect this could have on earnings per share to the common shareholders. Details
about diluted earnings per share will be covered in the next intermediate accounting course.
3.5 Statement of Changes in Equity (IFRS) and Statement of

Retained Earnings (ASPE)
Recall that net income or loss is closed to retained earnings. For ASPE companies, there is
no comprehensive income (OCI) and therefore no AOCI account in equity. With this simpler
reporting requirement, ASPE companies report retained earnings in the balance sheet and
3.5. Statement of Changes in Equity (IFRS) and Statement of Retained Earnings (ASPE) 57
detail any changes in retained earnings that took place during the reporting period in the
statement of retained earnings. An example of a statement of retained earnings is that of
Arctic Services Ltd., for the year ended December 31, 2020.
Arctic Services Ltd.

Statement of Retained Earnings
For the Year Ended December 31, 2020
Balance, January 1, as reported $ 250,000

Cumulative effect on prior years of retrospective application
of changing inventory costing method from FIFO
to moving weighted average
(net of taxes for $5,400) 12,600
Correction for an overstatement of net income from a prior period
due to an ending inventory error (net of $3,000 tax recovery) (7,000)
Balance, January 1, as adjusted 255,600
Net income 80,500
336,100
Cash dividends declared $(75,000)
Stock dividends declared (60,000) (135,000)
Balance, December 31 $ 201,100
As discussed at the beginning of this chapter, any error corrections from prior periods or
allowable changes in accounting policies will result in a reporting requirement to restate the
opening retained earnings balance for the current period. Each error and change in accounting
policy item is separately reported, net of tax, with the tax amount disclosed. The retained
earnings opening balance is restated and a detailed description is included in the notes to the
financial statements. The journal entry for the two restatement items for Arctic Services would
be:
General Journal
Date Account/Explanation PR Debit Credit
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000
Income tax payable . . . . . . . . . . . . . . . . . . . . . . . . 5,400
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . 12,600
General Journal
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000
Income tax payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
The statement of retained earnings also includes any current period net income or loss fol-
lowed by any cash or stock dividends declared by the board of directors. This detail provides
important information to investors and creditors regarding the proportion of net income that
is distributed to the shareholders through a dividend compared to the net income retained for
future business purposes such as investment or expansion.
ASPE companies may choose to combine the statement of income and the statement of
retained earnings. In this case, the statement of retained earnings is incorporated at the
bottom of the statement of income, starting with net income as shown in a simple example
below:
Net income $$$

Retained earnings, January 1 $$$
Dividends declared $$$
Retained earnings, December 31 $$$
For IFRS companies, net income is closed out to retained earnings, and other comprehensive
income (OCI), if any, is closed out to accumulated other comprehensive income (AOCI). An
example of how that works is illustrated in the Wellbourn financial statements included in
section 3.3 of this chapter. Both retained earnings and AOCI are reported in the equity section
of the statement of financial position (SFP) and the statement of changes in equity (IFRS).
For IFRS companies, each account from the equity section of the SFP is to be reported in
the statement of changes in equity. The following is an example of the statement of changes
in equity for an IFRS company, Velton Ltd., for the year ended December 31, 2020. Note
how this statement is worksheet style, which discloses each retrospective adjustment net of
tax, followed by a restatement of the equity account opening balances. Each equity account
opening balance is then reconciled to its respective closing balance by reporting the changes
that occurred during the year, such as the issuance/retirement of shares, net income, and
dividends. The statement also must report total comprehensive income. Any non-controlling
interest would also be reported (as a separate column), the same as was required and illus-
trated for Toulon Ltd.’s statement of income presented earlier.
Velton Ltd.
3.5. Statement of Changes in Equity (IFRS) and Statement of Retained Earnings (ASPE)
Accumulated Other
Preferred Common Contributed Retained Comprehensive
Shares Shares Surplus Earnings Income Total
Balance, January 1 $100,000 $500,000 $15,000 $ 450,000 $ 22,000 $1,087,000
Cumulative effect on prior years of retrospective
application of changing inventory costing
method from FIFO to moving weighted average
(net of taxes for $15,000) 35,000 35,000
Correction for an overstatement of net income from
a prior period due to an ending inventory error
(net of $6,000 tax recovery) (20,000) (20,000)
Balance, January 1, as restated 100,000 500,000 15,000 465,000 22,000 1,102,000
Total comprehensive income:
Net income 125,000 125,000
Other Comprehensive Income –
unrealized gain — FVOCI investments** 3,500 3,500
Total comprehensive income 125,000 3,500 128,500
Issuance of common shares 100,000 100,000
Balance, December 31 $100,000 $600,000 $15,000 $ 540,000 $ 25,500 $1,280,500
** net of related tax of $800. May be reclassified subsequently to net income or loss
The equity portion of the SFP is shown below.
59
Velton Ltd.
Statement of Changes in Financial Position
Shareholders’ Equity Section
December 31, 2020
Shareholder’s equity
Paid-in capital:
Preferred shares, non-cumulative, 2,000 authorized;
1,000 issued and outstanding $ 100,000
Common shares, unlimited authorized;
20,000 issued and outstanding 600,000
Contributed surplus 15,000
715,000
Accumulated other comprehensive income 25,500
Total shareholders’ equity $1,280,500
If the company sustained net losses over several years and retained earnings were insufficient
to absorb these losses, retained earnings would have a debit balance and would be reported
on the SFP as a deficit.
3.6 Analysis of Statement of Income and Statement of Changes in

Equity
Financial statement analysis is an evaluative process of determining the past, current, and
projected performance of a company. Financial statements report financial data; however, this
information must be evaluated to be more useful to investors, shareholders, managers, and
other stakeholders. Several techniques are commonly used for financial statement analysis.
They were originally presented in the introductory accounting course. A summary review of
these techniques follows.
Horizontal analysis compares two or more years of financial data in both dollar amounts and
percentage form. An income statement and SFP/BS with comparative data from prior years
are examples of where horizontal analysis is incorporated into the financial statements to en-
hance evaluation. Trends can emerge that are considered as either favourable or unfavourable
in terms of company performance.
Vertical or common-size analysis occurs when each category of accounts on the income
statement or SFP/BS is shown as a percentage of a total. For example, vertical analysis
is used to evaluate the statement of income such as the percentage that gross profit is to
3.6. Analysis of Statement of Income and Statement of Changes in Equity 61
sales or the percentages that operating expenses are to sales. Similarly, vertical analysis of
the SFP/BS may be used to evaluate what percentage equity is to total assets. This ratio
tells investors what proportion of the net assets is being retained by the company’s investors
compared to the company’s creditors.
Ratio analysis calculates statistical relationships between data. Ratio analysis is used to
evaluate various aspects of a company’s financial performance such as its efficiency, liquidity,
profitability, and solvency. Gross profit ratio (gross profit divided by net sales and/or revenue)
and earnings per share (EPS) are examples of key ratios used to evaluate income and changes
in equity. One of the most widely used ratios by investors to assess company performance is
the price-earnings (P/E) ratio (market price per share divided by EPS). The P/E ratio is the
most widely quoted measure that investors use as an indicator of future growth and of risk
related to a company’s earnings when establishing the market price of the shares. The trend
of the various ratios over time is assessed to see if performance is improving or deteriorating.
Ratios are also assessed across different companies in the same industry sector to see how
they compare. Ratios are a key component to financial statement analysis.
Segmented Reporting
The statement of income can be segmented, or disaggregated, to enhance performance

analysis. The statement can be segmented in various ways such as by geography or by
type of product or service. As a point of interest, other segmented financial statements include
the SFP/BS and the statement of cash flow covered in the next chapter.
For ASPE, there is currently no guidance regarding segmented reporting. For IFRS com-
panies, a segment must meet several characteristics and quantitative thresholds to be a
reportable segment for purposes of the published financial statements. Segmented reporting
can set apart business components that have a strong financial performance from those that
are weak or are negative “losing” performers. Management can use this information to make
decisions about which components to keep and which components to discontinue as part of
their overall business strategy. Keep in mind that not all business components that experience
chronic losses should be automatically discontinued. There are strategic reasons for keeping
a “losing” component. For example, retaining a borderline, or losing, segment that produces
parts may guarantee access to these critical parts when needed for production of a much
larger product to continue uninterrupted. If the parts manufacturing component is discontinued
and disposed, this guaranteed access will no longer exist and production in the larger sense
can quickly grind to a halt, affecting company sales and profits. Segmented reporting can also
assist in forecasting future sales, profits, and cash flows, since different components within a
company can have different gross margins, profitability, and risk.
There can be issues with segmented reporting. For example, accounting processes such as
allocation of common costs and elimination of inter-segment sales can be challenging. A thor-
ough knowledge of the business and the industry in which the company operates is essential
when utilizing segmented reports; otherwise, investors may find segmentation meaningless
or, at worst, draw incorrect conclusions about the performance of the business components.
There can be reluctance to publish segmented information because of the risk that competi-
tors, suppliers, government agencies, and unions can use this information to their advantage
and to the detriment of the company.
3.7 IFRS and ASPE Applicable Standards
CPA Canada Handbook, Part 1 (IFRS) – IAS 1, Presentation of Financial Statements, IAS 8,
Accounting Policies, Changes in Accounting Estimates and Errors, IFRS 5, non-current assets
held for sale and discontinued operations
CPA Canada Handbook, Part 2, (ASPE) – Sections 1400 general standards of financial state-
ment presentation, Section 1506, Accounting changes, Section 1520, Income Statement, and
Section 3475, Disposal of long-lived assets and discontinued operations
Chapter Summary
LO 1: Describe statement of income, the statement of comprehensive income, and

the statement of changes in equity, and their role in accounting and business.
The statement of income reports on company performance over the reporting period in terms
of net income. The statement of comprehensive income is a concept only used by IFRS
companies that reports on other gains and losses not already reported in net income. The
statement of changes in equity (IFRS) reports on what changes took place in each of the
equity accounts for the reporting period. For ASPE, this statement is a much simpler statement
of retained earnings. Together, these statements enable the company stakeholders such as
management, investors, and creditors to assess the financial health of the company and its
ability to generate profits and repay debt. Each accounting standard (IFRS and ASPE) has
minimum reporting requirements, which were discussed in this chapter.
LO 2: Identify the factors that influence what is reported in the statement of

income, the statement of comprehensive income, and the statement of changes
in equity.
The accounting standards require that all statements are reported on an accrual basis over
a specific period of time (periodicity assumption) so that anything relevant to decision making
is included (full disclosure principle). To ensure this, various adjusting entries are recorded to
Chapter Summary 63
make certain that the accounting records are up to date, and an accounting fiscal year-end
date is carefully chosen. Accrual entries include any revenues earned but not yet recorded,
whether paid or not (revenue recognition principle), and any expenses where goods and
services have been received but not yet recorded, whether paid or not (matching principle).
Other adjusting entries include prepayment items (prepaid expenses and unearned revenues),
the estimate for bad debt expense, depreciation and amortization of depreciable assets, unre-
alized gains and losses of certain assets, and any impairment or write-down entries, if required.
Also considered are subsequent events that occur after the year-end date and whether to
include them in the financial statements or in the notes to the financial statements. Changes
in accounting estimates (prospective treatment with restatement), correcting accounting errors
(retrospective treatment with restatement), and changes in accounting policy (retrospective
treatment) can all affect the financial statements.
LO 3: Identify the core financial statements and explain how they interconnect
together.
The core financial statements interconnect to complete an overall picture of a company’s

performance over the reporting period (income statement) as well as its current financial
state (SFP/BS). Starting with performance, the net income from the statement of income
becomes the first amount reported on the statement of comprehensive income. Added to that
is other comprehensive income (OCI), which reports any gains or losses not already reported
in net income (IFRS only). Net income and OCI each flow to the statement of changes
in equity, which reports on all the items that have affected the equity accounts during the
reporting period. Together, these three financial statements are used to assess the company
performance for the reporting period. The statement of cash flows reconciles cash and cash
equivalent opening balances at the beginning of the reporting period to the closing balances
at the end of the period. These changes are broken down into sources of cash inflows and
outflows. Cash inflows could be from customers, issuing debt, or issuing share capital, while
cash outflows could be from payments to suppliers, to employees, the purchase of assets, the
payment of debt, any retirement of share capital, or the payment of dividends. These activities
are separated and reported into the operating, investing, and financing section. The net
amount of change represents the total change between the opening cash and cash equivalent
balance to the closing cash and cash equivalent balance. The SFP/BS completes the set of
core financial statements. It provides a snapshot at the end of the reporting period, such as
month-end or year-end, and identifies the company resources (assets) and the claims to these
resources (liabilities). The remaining net assets belong to the various classes of shareholders.
The ending cash and cash equivalent balance of the statement of cash flow must reconcile to
the cash and cash equivalent balances in the SFP/BS, and the statement of changes in equity
totals must reconcile to the SFP/BS equity section, so that all the statements fit together into
a single reconciled network of financial information.
There are differences between IFRS and ASPE reporting standards. For APSE, the statement
of income is quite similar but without the requirement for comparative years’ data and earnings
per share reporting. Comprehensive income is not a concept used by ASPE so there is no
requirement for a statement of comprehensive income. ASPE companies report any changes
in retained earnings through the statement of retained earnings, which is a much simpler
statement that reports only the changes in the retained earnings account compared to the
statement of changes in equity (IFRS), which reports the changes for all equity accounts.
LO 4: Describe the various formats used for the statement of income and the
statement of comprehensive income, and identify the various reporting
requirements for companies following IFRS and ASPE.
The purpose of the statement of income is to identify the revenues and expenses that comprise
a company’s net income. A comprehensive income statement, required by IFRS, identifies any
gains and losses not already included in the statement of income. Together, these statements
enable management, creditors, and investors to assess a company’s financial performance for
the reporting period. Comparing current with past performance, stakeholders can use these
statements to predict future earnings and profitability. Since accounting is accrual-based,
uncertainty exists in terms of the accuracy and reliability of the data used in the estimates. Net
income (earnings) that can be attributable to sustainable ongoing core business activities are
higher quality earnings than artificial numbers generated from applying accounting processes,
determining various estimates, or gains and losses from non-operating business activities.
The lower the quality of earnings, the less reliance will be placed on them by investors and
creditors.
The statement of income can be a simple single-step or a more complex multiple-step format.
Either one has its advantages and disadvantages. No matter which format is used, certain
mandatory reporting requirements for both IFRS and ASPE exist, such as separate reporting
for continuing operations and discontinued operations. To be reported as a discontinued
operation, the business component must meet the definition of a cash-generating unit and
a formal plan to dispose of the business component must exist. Companies can choose
to report operating expenses by nature (type of expense) or by function (which department
incurred the expense). However, if expenses by function is used, additional reporting of certain
line items by nature is still required for both IFRS and ASPE companies such as inventory
expensed, depreciation, amortization, finance costs, inventory write-downs, and income taxes
to name a few. IFRS companies can choose to keep the statement of income separate from the
statement of comprehensive income or combine them into a single statement: the statement
of income and comprehensive income. For IFRS companies, the earnings per share are
reporting requirements.
Exercises 65
LO 5: Describe the various formats used to report the changes in equity for IFRS
and ASPE companies, and identify the reporting requirements.
For ASPE companies the various sources of change occurring during the reporting period for
retained earnings is reported, while for IFRS companies changes to each of the equity ac-
counts is identified, usually in a worksheet style with each account assigned to a column. One
important aspect to either statement is the retrospective reporting for changes in accounting
policies or corrections of errors from prior periods. The opening balance for retained earnings
is restated by the amount of the change or error, net of tax, with the tax amount disclosed.
Other line items for these statements include net income or loss and dividends declared. For
IFRS companies reporting will also include any changes to the share capital accounts and
accumulated other comprehensive income (resulting from OCI items recorded in the reporting
period).
LO 6: Identify and describe the types of analysis techniques that can be used for
income and equity statements.
Analysis of the financial statements is critical to decision making and to properly assess the
overall financial health of a company. Analysis transforms the data into meaningful information
for management, investors, creditors, and other company stakeholders. By evaluating the
financial data, trends can be identified which can be used to predict the company’s future
performance. Some techniques used on financial statements include horizontal analysis that
compares data from multiple years, vertical analysis that expresses certain subtotals (gross
profit) as a percentage of a total amount (sales), and ratio analysis that highlights important
relationships between data.
References
CPA Canada. (2011). CPA Canada handbook, Part I, IAS 8.
Jones, J. (2014, September 19). Restated Penn West results reveal cut to cash flow. The
Globe and Mail. Retrieved from https://secure.globeadvisor.com/servlet/ArticleNew
s/story/gam/20140919/RBCDPENNWESTFINAL
Exercises
EXERCISE 3–1
The following information pertains to Inglewood Ltd. for the 2020 fiscal year ending December
31:
Gain on sale of FVNI investments (before tax): $ 1,500

Loss from operation of discontinued division (net of tax) 2,500
Loss from disposal of discontinued division (net of tax) 3,500
Income from operations (before tax) 125,000
Unrealized holding gain of FVOCI investments (net of tax) 12,000
The company tax rate is 27%. The unrealized holding gain is from FVOCI investments where
the gain has been recorded to other comprehensive income (OCI).
Required:
a. Calculate income from continuing operations, net income, other comprehensive income,
and total comprehensive income.
b. How would your answers change in part (a) if the company followed ASPE?
EXERCISE 3–2
Wozzie Wiggits Ltd. produces and sells gaming software. In 2020, Wozzie’s net income
exceeded analysts’ expectations in the stock markets by 8%, suggesting an 8% increase from
operations. Included in net income was a significant gain on sale of some unused assets. The
company also changed their inventory pricing policy from FIFO which is currently being used
in their industry sector to weighted average cost, causing a significant drop in cost of goods
sold. This policy change was fully disclosed in the notes to the financial statements.
Required: Based solely on the information above, do you think that Wozzie’s earnings are of
high quality? Would you be willing to invest in this company based on the quality of earnings
noted in the question?
EXERCISE 3–3
Eastern Cycles Ltd. is a franchise that sells bicycles and cycling equipment to the public. It
currently operates several corporate-owned retail stores in Ottawa that are not considered
a separate major line of business. It also has several franchised stores in Alberta. The
franchisees buy all of their products from Eastern Cycles and pay 5% of their monthly sales
revenues to Eastern Cycles in return for corporate sponsored advertising, training, and sup-
port. Eastern Cycles continues to monitor each franchise to ensure quality customer service.
In 2020, Eastern Cycles sold its corporate owned stores in Ottawa to a franchisee.
Exercises 67
Required: Would the sale of the franchise meet the classification of a discontinued operation
under IFRS or ASPE?
EXERCISE 3–4
For the year ended December 31, 2020, Bunsheim Ltd. reported the following: sales rev-
enue $680,000; cost of sales $425,750; operating expenses $75,000; and unrealized gain
on Available-for-sale investments $25,000 (net of related tax of $5,000). The company had
balances as at January 1, 2020, as follows: common shares $480,000; accumulated other
comprehensive income $177,000; and retained earnings $50,000. The company did not
issue any common shares during 2020. On December 15, 2020, the board of directors
declared a $45,000 dividend to its common shareholders payable on January 31, 2021. The
company accounts for its investments in accordance with IFRS 9 meaning that any unrealized
gains/losses on FVOCI investments are to be reported as other comprehensive income (OCI).
On January 4, 2021, the company discovered that there was an understatement in travel
expenses from 2019 of $80,000. The books for 2019 are closed.
Required
a. Prepare a statement of changes in equity including required disclosures. The enacted

tax rate is 27% and has not changed for several years.
b. Prepare the same statement as in part (a) assuming that Bunsheim Ltd. follows ASPE.
EXERCISE 3–5
For the year ended December 31, 2020, Patsy Inc. had income from continuing operations
of $1,500,000. During 2020, it disposed of its Calgary division at a loss before taxes of
$125,000. Before the disposal, the division operated at a before-tax loss of $150,000 in 2019
and $175,000 in 2020. Patsy also had an unrealized gain in its Availablefor-sale investments
(FVOCI) of $27,500 (net of tax). It accounts for its investments in accordance with IFRS 9.
Patsy had 50,000 outstanding common shares for the entire 2020 fiscal year and its income
tax rate is 30%.
Required:
a. Prepare a partial statement of comprehensive income with proper disclosures for Patsy
Inc. beginning with income from continuing operations. Patsy follows IFRS.
b. How would the statement in part (a) differ if Patsy followed ASPE?
EXERCISE 3–6
Below are the changes in account balances, except for retained earnings, for Desert Dorm
Ltd., for the 2020 fiscal year:
Account increase
(decrease)
Accounts payable $ (23,400)
Accounts receivable (net) 15,800
Bonds payable 46,500
Cash 41,670
Common shares 87,000
Inventory 218,400
Investments – FVNI (46,500)
Intangible assets – patents 14,000
Unearned revenue 45,200
Retained earnings ??
Required: Calculate the net income for 2020, assuming there were no entries in the retained
earnings account except for net income and a dividend declaration of $44,000, which was paid
in 2020. (Hint: using the accounting equation A = L + E to help solve this question)
EXERCISE 3–7
In 2020, Imogen Co. reported net income of $575,000, and declared and paid preferred share
dividends of $75,000. During 2020, the company had a weighted average of 66,000 common
shares outstanding.
Required: Calculate the company’s basic earnings per share.
EXERCISE 3–8
A list of selected accounts for Opi Co. is shown below. All accounts have normal balances.
The income tax rate is 30%.
Exercises 69
Opi Co.
For the year ended December 31, 2020
Accounts payable $ 63,700
Accounts receivable 136,500
Accumulated depreciation – building 25,480
Accumulated depreciation – equipment 36,400
Administrative expenses 128,700
Allowance for doubtful accounts 6,500
Bond payable 130,000
Buildings 127,400
Cash 284,180
Cost of goods sold 1,020,500
Dividends 58,500
Equipment 182,000
Error correction for understated cost of goods sold from 2019 13,500
Freight-out 26,000
Gain on disposal of discontinued operations – South Division 27,560
Gain on sale of land 39,000
Inventory 161,200
Land 91,000
Miscellaneous operating expenses 1,560
Notes payable 91,000
Notes receivable 143,000
Rent revenue 23,400
Salaries and wages payable 23,500
Sales discounts 18,850
Sales returns and allowances 22,750
Sales revenue 1,820,000
Selling expenses 561,600
Required:
a. Prepare a single-step income statement with expenses by function and a separate state-
ment of retained earnings assuming that Opi is a private company that follows ASPE.
b. Prepare a combined single-step income statement and retained earnings by function

assuming ASPE.
EXERCISE 3–9
Below are adjusted accounts and balances for Ace Retailing Ltd. for the year ended December
31, 2020:
Cost of goods sold 750,000

Dividends declared (common shares) 245,000
Dividends declared (preferred shares) 82,000
Gain on disposal of discontinued J division 115,000
Gain on sale of FVNI investments 45,000
Interest income 15,000
Loss on impairment of goodwill 12,000
Loss due to warehouse fire 175,000
Loss from operation of discontinued J division 285,000
Loss on disposal of unused equipment from F division 82,000
Retained earnings, January 1, 2020 458,000
Selling and administrative expenses 245,000
Unrealized gain on FVOCI investments (OCI) 18,600
Additional information:
1. Ace decided to discontinue the J division operations. A formal plan to dispose of J

division has been completed. There are no plans to dispose of F division at this time.
2. During 2020, 400,000 common shares were outstanding with no shares activity for 2020.
3. Ace’s tax rate is 27%.
4. Ace follows IFRS and accounts for its investments in accordance with IFRS 9 meaning
that any unrealized gains/losses for FVNI are reported through net income and FVOCI
are reported in OCI.
Required:
a. Prepare a multiple-step statement of income for the year ended December 31, 2020, in
good form reporting expenses by function.
b. Prepare a combined statement of income and comprehensive income in good form

reporting expenses by function.
c. How would the answer in part (b) differ if a statement of comprehensive income were to
be prepared without combining it with the statement of income?
d. Prepare a single-step statement of income in good form reporting expenses by function.
e. Explain what types of items are to be reported in other revenue and expenses as part of
continuing operations, and provide examples for a retail business.
Exercises 71
EXERCISE 3–10
Vivando Ltd. follows IFRS and reported income from continuing operations before income
tax of $1,820,000 in 2020. The year-end is December 31, 2020, and the company had
225,000 outstanding common shares throughout the 2020 fiscal year. Additional transactions
not considered in the $1,820,000 are listed below:
In 2020, Vivando sold equipment of $75,000. The equipment had originally cost $92,000 and
had accumulated depreciation to date of $33,400. The gain or loss is considered ordinary.
The company discontinued operations of one of its subsidiaries, disposing of it during the
current year at a total loss of $180,600 before tax. Assume that this transaction meets the
criteria for discontinued operations. The loss on operation of the discontinued subsidiary was
$68,000 before tax. The loss from disposal of the subsidiary was $112,600 before tax.
The sum of $180,200 was received because of a lawsuit for a breached 2016 contract. Before
the decision, legal counsel was uncertain about the outcome of the suit and had not estab-
lished a receivable.
In 2020, the company reviewed its accounts receivable and determined that $125,600 of
accounts receivable that had been carried for years appeared unlikely to be collected. No
allowance for doubtful accounts was previously set up.
An internal audit discovered that amortization of intangible assets was understated by $22,800
(net of tax) in a prior period. The amount was charged against retained earnings.
Required: Analyze the above information and prepare an income statement for the year 2020,
starting with income from continuing operations before income tax (Hint: refer to the Toulon
Ltd. example in Section 4 of this chapter). Calculate earnings per share as it should be shown
on the face of the income statement. Assume a total effective tax rate of 25% on all items,
unless otherwise indicated.
EXERCISE 3–11
The following account balances were included in the adjusted trial balance of Spyder Inc. at
September 30, 2020. All accounts have normal balances:
Accumulated depreciation, office furniture 25,000

Accumulated depreciation, sales equipment 80,000
Accumulated Other Comprehensive Income 162,000
Depreciation expense, office furniture 10,150
Depreciation expense, sales equipment 6,972
Depreciation expense, understatement due to error – 2019 24,780
Dividend revenue 53,200
Dividends declared on common shares 12,600
Entertainment expense 20,748
Freight-out 40,502
Interest expense 25,200
Loss on disposal of discontinued operations – Aphfflek Division 49,000
Miscellaneous operating expenses (administrative) 6,601
Salaries and wages expense – office staff 78,764
Sales commissions expense 136,640
Sales discounts 21,000
Sales returns and allowances 87,220
Supplies expenses (administrative) 4,830
Telephone and Internet expense (administrative) 3,948
Telephone and Internet expense (sales) 12,642
The company follows IFRS and its income tax rate is 30%. On September 30, 2020, the
number of common shares outstanding was 124,000 and no changes to common shares
during the fiscal year. The depreciation error was due to a missed month-end accrual entry at
August 31, 2019.
Required:
a. Prepare a multiple-step income statement in good form with all required disclosures by
function and by nature for the year ending September 30, 2020.
b. Prepare a statement of changes in equity in good form with all required disclosures for
the year ended September 30, 2020.
c. Prepare a single-step income statement in good form with all required disclosures by
nature for the year ending September 30, 2020, assuming this time that the dividends
declared account listed in the trial balance are for preferred shares instead of common
shares.
Exercises 73
d. Assuming that Spyder also recorded unrealized gains for FVOCI investments through
OCI of $25,000, prepare a statement of comprehensive income for the company.
Chapter 4
Financial Reports – Statement of Financial Posi-
tion and Statement of Cash Flows
Amazon’s Cash Flow Position
In 2014, Amazon reported its quarterly earnings for their year-to-date earnings release.
Since the trend has been for their profits to slide downward in the recent past, initial
speculation was that this was causing investor discontent resulting in decreasing stock
prices. But was it?
Even though profits were on a downward trend, the earnings releases showed that the
operating section of the statement of cash flow (SCF) was reporting some healthy net
cash balances that were much higher than net income. This is often caused by net income
including large amounts of non-cash depreciation expense.
Moreover, when looking at free cash flow, it could be seen that Amazon had been making
huge amounts of investment purchases, causing a sharp drop in the free cash flow levels
compared to the operating section of the SCF. However, even with these gigantic invest-
ment purchases, free cash flow continued to soar well above its net income counterpart by
more than $1 billion. What this tells investors is that there are timing differences between
what is reported as net income on an accrual basis and reported as cash flows on strictly
a cash basis.
The key to such cash flows success lies in the cash conversion cycle (CCC). This is a
metric that measures how many days it takes for a company to pay it suppliers for its
resale inventory purchases compared to how many days it takes to convert this inventory
back into cash when it is sold and the customer pays their account. For example, if it takes
45 days to pay the supplier for resale inventory and only 40 days to sell and receive the
cash from the customer, this creates a negative CCC of 5 days of access to additional
cash flows. In industry, Costco and Walmart have been doing well at maintaining single-
digit CCC’s but Amazon tops the chart at an impressive negative 30.6 days in 2013. Apple
also managed to achieve a negative CCC in 2013, making these two companies cash-
generating giants in an often-risky high-tech world.
Amazon is using this internal access to additional cash to achieve significant levels of
growth; from originally an online merchant of books to a wide variety of products and
services, and, most recently, to video streaming. Simply put, Amazon can expand without
borrowing from the bank, or from issuing more stock. This has landed Amazon’s founder
and CEO, Jeff Bezoz, an enviable spot in Harvard Business Review’s list of best performing
CEOs in the world.
75
76 Financial Reports – Statement of Financial Position and Statement of Cash Flows
So, which part of the CCC metric is Amazon leveraging the most? While it could be good
inventory management, it is not. It is the length of time Amazon takes to pay its suppliers.
In 2013, the company took a massive 95.8 days to pay its suppliers, a fact that suppliers
may not be willing to accept forever.
Though it might have been too early to tell, some of the more recent earnings release
figures for Amazon are starting to show the possibility that the CCC metric may be starting
to increase. This shift might be a cause for concern for the investors. Moreover, this could
be the real reason why Amazon’s stock price was faltering in 2014 rather than because of
the decreasing profits initially considered by many to be the culprit.
(Source: Fox, 2014)
After completing this chapter, should be able to:
LO 1: Describe the statement of financial position/balance sheet (SFP/BS) and the state-
ment of cash flows (SCF), and explain their role in accounting and business.
LO 2: Explain the purpose of the SFP/BS.
LO 2.1: Identify the various disclosure requirements for the SFP/BS and prepare a SFP/BS
in good form.
LO 2.2: Identify and describe the factors can affect the SFP/BS, such as changes in
accounting estimates, changes in accounting policies, errors and omissions,
contingencies and guarantees, and subsequent events.
LO 3: Explain the purpose of the statement of cash flows (SCF) and prepare a SCF in good
form.
LO 3.1: Explain and describe an acceptable format for the SCF.

LO 3.2: Describe and prepare a SCF in good form with accounts analysis as required,
and interpret the results.
LO 4: Identify and describe the types of analysis techniques that can be used for the SFP/BS
and the SCF.
Introduction 77
Introduction
In Chapter 3 we discussed three of the core financial statements. This chapter will now
discuss the remaining two, which are the SFP/BS, and the SCF. Both of these statements
are critical tools used to assess a company’s financial position and its current cash resources,
as explained in the opening story about Amazon. Cash is one of the most critical assets
to success as will be discussed in a subsequent chapter on cash and receivables. How an
investor knows when to invest in a company and how a creditor knows when to extend credit
to a company is the topic of this chapter.
NOTE: IFRS refers to the balance sheet as the statement of financial position (SFP) and ASPE
continues to use the term balance sheet (BS). To simplify the terminology, this chapter will refer
to this statement as the SFP/BS, unless specific reference to either one is necessary.
Disclosure
Requirements
Factors Affecting
the SFP/BS
Changes in
Estimates
1.0 Financial
Reports: Overview Accounting Errors
and Omissions
2.0 Statement
of Financial Changes in
Position/Balance Accounting Policy
Financial Reports Sheet (SFP/BS)
Statement of Financial
Position and Statement Contingencies
of Cash Flows and Guarantees
Subsequent Events
3.0 Statement of
Cash Flows (SCF)
Preparing a Statement
of Cash Flows
4.0 Analysis
Disclosure
Requirements
Interpreting the
Statement of
Cash Flows
4.1 Financial Reports: Overview
As discussed previously, investors and creditors assess a company’s overall financial health
by using published financial statements. Recall that the previous chapter about financial
reporting illustrated how the core financial statements link into a cohesive network of financial
information. The illustration in that chapter showed how the ending cash balance from the
statement of cash flows (SCF) is also the ending cash balance in the SFP/BS. This is the final
link that completes the connection of the core financial statements.
For example, in the SFP/BS for Wellbourn Services Ltd. at December 31 (which we saw also
4.1. Financial Reports: Overview 79
in the previous chapter) note how the cash ending balance links the two statements.

December 31, 2020
Assets Liabilities
Current assets Current liabilities
Cash $135,500 Accounts payable $ 77,500
Accounts receivable (net) 225,000 Accrued liabilities 225,000
Inventory 130,000 Total current liabilities 302,500
Total current assets 490,500 Bonds payable 160,000
Investments 100,000 Total liabilities 462,500
Property, plant, and equipment (net) 246,000 Equity
Intangible assets 15,000 Common shares 210,000
Total assets $851,500 Contributed surplus 25,000
AOCI 48,500
Total equity 389,000
Liabilities and equity $851,500

Cash received from clients $ 50,000
Cash paid for supplies (25,000)
Cash paid to employees (51,200)
Purchase of equipment (25,000)
Net cash used by investing activities (25,000)
Issued bonds 160,000
Net cash received by financing activities 110,000
Cash balance, January 1 76,700
Cash balance, December 31 $ 135,500
The SFP/BS provides information about a company’s resources (assets) at a specific point
in time and whether these resources are financed mainly by debt (current and long-term
liabilities) or equity (shareholders’ equity). In other words, the SFP/BS provides the information
needed to assess a company’s liquidity and solvency. Combined, these represent a company’s
financial flexibility.
Recall the basic accounting equation:

Assets = Liabilities + Equity
The key issues to consider regarding the SFP/BS are the valuation and management of
resources (assets) and the recognition and timing of debt obligations (liabilities). Reporting
the results within the SFP/BS creates a critical reporting tool to assess a company’s overall
financial health.
The statement of cash flows, discussed later in this chapter, identifies how the company utilized
its cash inflows and outflows over the reporting period. Since the SCF separates cash flows
into those resulting from operating activities versus investing and financing activities, investors
and creditors can quickly see where the main sources of cash originate. If cash sources are
originating more from investing activities than from operations, this means that the company
is likely selling off some of its assets to cover its obligations. This may be appropriate if these
assets are idle and no longer contributing towards generating profit, but otherwise, selling off
useful assets could trigger a downward spiral, with profits plummeting as a result. If cash
sources are originating mainly from financing activities, the company is likely sourcing its cash
from debt or from issuing shares. Higher debt requires more cash to make the principal and
interest payments, and more shares means that existing investors’ ownership is becoming
diluted. Either scenario will be cause for concern for both investors and creditors. Even if most
of the cash sources are mainly from operating activities, a large difference between net income
and the total cash from operating activities is a warning sign that investors and creditors should
be digging deeper.
The bottom line after reviewing the two statements is: if debt is high and cash balances are
low, the greater the risk of failure.
The SFP/BS will now be discussed in detail.
4.2 Statement of Financial Position/Balance Sheet
The purpose of the SFP/BS is to report the assets of a company and the composition of the
claims against those assets by creditors and investors at a specific point in time. Assets and
liabilities come from several sources and are usually separated into current and non-current
(IFRS) or long-term (ASPE) categories.
4.2.1 Disclosure Requirements
IFRS (IAS 1) and ASPE (section 1521) identify the disclosure requirements for SFP/BS, which
are quite similar. Listed below are summary points for some of the more commonly required
4.2. Statement of Financial Position/Balance Sheet 81
disclosures for both standards:
• The application of the standards is required, with additional disclosures when necessary,
so that the SFP/BS will be relevant and faithfully representative. Relevance means
that the information in the SFP/BS can make a difference in decision-making. Faithfully
representative means that the statement is complete, neutral, and free from errors.
• Any material uncertainties about a company’s ability to continue as a going concern are
to be disclosed.
• Company name, name of the financial statement, and date must be provided.
• The SFP/BS is to report assets and liabilities separately in many cases. The schedule
below lists many of the more common assets and liabilities that are to be separately
reported.
In addition, any material classes of similar items are to be separately disclosed in either
the statement or in the notes to the financial statements (e.g., items of property, plant,
and equipment, types of inventories, or classes of equity share capital).
• When preparing the SFP/BS, assets are not to be netted with liabilities. This does not
apply to contra accounts.
• Assets and liabilities are to be separated into current and non-current (long-term). Some
companies further report assets in order of their liquidity.
• The measurement basis used for each line item in the statement is to be disclosed.
Examples would be whether the company applied fair value, fair value less costs to
sell, cost, amortized cost, net realizable value, or lower of cost and net realizable value
(LCNRV) when preparing the statement.
• Due dates and interest rates for any financial instruments payable such as loans, notes,
mortgages, and bonds payable, as well as details about any security required for the
loan are to be disclosed.
• Cross-reference note disclosures to the related line items in the statement.
Below are the basic classifications for some of the more common reporting line items and
accounts. The focus is mainly IFRS for simplicity, though ASPE is substantially similar. The
required supplemental disclosures below focus on the measurement basis of the various
assets, the due dates, interest rates, and security conditions for non-current liabilities; and
the structure for each class of share capital in shareholders’ equity when preparing a SFP/BS.
These will be discussed in more detail in the chapters that follow in the next intermediate
accounting course.
SFP/BS – Classifications and Reporting Requirements

Classification Report Line Items Includes Measurement Basis and

Other Required
Disclosures at Each
Reporting Date
Current assets – assets Cash and cash Currency, coin, bank Fair value, stated in local
realized within one year equivalents accounts, petty cash, currency. Restricted
from the reporting date (unrestricted) treasury bills maturing cash and compensating
or the operating cycle, within three months at balances are reported
whichever is longer acquisition separately as a current
or long-term asset, as
appropriate.
Investments – trading Equity investments such Usually fair value
as shares purchased to
sell within a short time
Accounts receivable Trade receivables net of Net realizable value as a
allowance for doubtful fair value measure
account (AFDA)
Related party Amounts owing by Carrying amount or
receivables related parties exchange amount
Notes receivable Notes receivable within Net realizable value
one year
Inventories Raw materials, Lower of cost and net
work-in-process, finished realizable value
goods held for sale, or (LCNRV) using FIFO,
goods held for resale weighted average cost
or specific identification
Supplies on hand Supplies that are Usually invoice cost
expected to be
consumed within one
year
Prepaid expenses Cash paid items where Usually invoice cost
the expense is to be
incurred within one year
of the reporting date
Assets held for sale Land, buildings, and If criteria met (ASPE),
equipment no longer lower of carrying less
used to generate income costs to sell
Income taxes receivable Income taxes receivable Based on tax rate
based on current taxable
loss
Deferred income tax Current portion of ASPE only
assets deferred income taxes
avoided/saved arising Under IFRS, all deferred
from differences tax is non-current
between accounting
income/loss and taxable
income/loss

Other Required
Disclosures at Each
Reporting Date
Non-current / long-term Investments – Debt and equity AC – cost, amortized
assets non-strategic investments such as cost
held to maturity to collect
principal and interest FVOCI – fair value
(AC), fair value through through OCI (IFRS only)
OCI to collect principal
and interest and to sell FVNI – fair value through
(FVOCI), and FVNI for net income - debt or
all else equity investments not
classified as FVOCI
(IFRS), or equity
investments in active
markets (ASPE)
Investments – strategic Associate/Significant IFRS – equity method
Influence equity
investments in shares ASPE – equity method,
cost method, or FVNI
Joint-ventures and Equity investments of Partial or full
subsidiaries greater than 50% of the consolidation
investee company’s
outstanding shares
Investment property Land or building held as Usually fair value
an investment
Biological assets Dairy cattle, pigs, sheep, IFRS – fair value less
farmed fish, trees for costs to sell
timber, trees or vines for
fruit ASPE – N/A
Property, plant, and Tangible assets used to Land – cost
equipment generate income such
as land, buildings, All else – amortized cost
machinery, equipment,
furniture IFRS also allows fair
value (revaluation);
accumulated
depreciation disclosed
separately
Intangible assets Copyrights, customer Finite life and indefinite
lists, franchises, patents, life – initially cost, and
trademarks, trade subsequently cost less
names accumulated
amortization (finite life
only) net of accumulated
impairment losses (both)
Accumulated
amortization disclosed
separately

Other Required
Disclosures at Each
Reporting Date
Goodwill Purchased goodwill Goodwill – excess of
purchase price over fair
values of net identifiable
assets and tested
annually for impairment
Deferred income tax Non-current portion of IFRS and ASPE
assets deferred income taxes
avoided/saved arising
from differences
between accounting
income/loss
Current liabilities – Bank indebtedness or Amounts owing to the Fair value or contract
obligations due within bank overdraft bank that cannot be amount stated in local
one year from the offset by a same-bank currency
reporting date or the positive balance,
operating cycle, amount, and is payable
whichever is longer on demand
Accounts payable Trade payables, such as Invoice cost, net of
suppliers’ invoices owing realized discounts
for goods and services
received
Notes and loans payable Notes and loans due Also includes principal
within one year portion of long-term debt
obligation due within one
year of the reporting
date
Accrued liabilities Adjusting entries for Invoice or contract cost
various types of
expenses incurred but
not paid such as
salaries, benefits,
interest, property taxes,
non-trade payables
Unearned revenue Cash received in Consideration amount
advance for goods and received
services not yet provided
to customer
Income taxes payable Income taxes payable Based on taxable
based on current taxable income at the current tax
income rate
Deferred income tax Current portion of ASPE only
liabilities deferred income taxes
expected to be owed
and arising from
differences between
accounting income/loss
and taxable income/loss

Other Required
Disclosures at Each
Reporting Date
Non-current/long-term Long-term debt payable Long-term mortgages, Each item is reported
liabilities bonds, notes, loans, separately
capital leases net of
current portions, Measurement basis
long-term construction varies – amortized cost,
obligations fair value, discounted
present value, estimated
construction obligation,
and so on
Reporting requirements
include the amortization
period, due date, interest
rate and security
conditions
Employee pension Employer pension The net defined benefit
benefits payable obligations for the liability/asset is
shortfall between the determined by deducting
defined benefit the fair value of the plan
obligation (DBO) and the assets from the present
plan assets both of value of the defined
which are held and benefit obligation
reported through a
separate trust
Deferred income tax Non-current portion of IFRS and ASPE

liabilities deferred income taxes
expected to be owed
arising from differences
between accounting
income/loss
Equity – a company’s Share capital Preferred shares and The exchanged value
net assets, which is common shares of (transaction price less
equal to total assets various classes are each any transaction costs) of
minus total liabilities separately reported issued shares
Represents the The dividend amount,

ownership interest characteristics of each
share class, as well as
the number of shares
authorized, issued, and
outstanding for each
class of share

Other Required
Disclosures at Each
Reporting Date
Contributed surplus Gains from certain
shares transactions,
donated assets by a
shareholder, redemption
or conversion of shares
Retained Undistributed
earnings/(deficit) accumulated net income
If a negative number,
label as a “deficit”
Accumulated other Accumulated gains or IFRS only
comprehensive income losses reported in other
(AOCI) comprehensive income
(OCI) each reporting
period that are closed to
AOCI at the end of that
reporting period
Non-controlling Minority interest An equity claim for the
interest/minority interest portion of a subsidiary
corporation’s net assets
that are not owned by
the parent corporation
(third-party investors)
Note that in addition to the measurement basis identified for each asset category in the chart
above, many assets’ valuations can be subsequently adjusted, depending on the circum-
stances. Below are examples of some of the common valuation adjustments made to various
asset accounts that will be discussed in later chapters.
Cash and cash equivalents Foreign exchange adjustments for foreign currencies
Investments – trading Adjust to fair values, therefore no subsequent adjustment

for impairment
Accounts receivable and AFDA AFDA adjustments at each reporting date are the basis
for reporting accounts receivable at NRV
Related party receivables Adjust for impairment
Notes receivable Adjust for impairment
Inventory Adjust for cost of goods sold, shrinkage, obsolescence,

damage; reported at lower of cost and net realizable value
(LCNRV)
Supplies/office supplies Adjust for usage, shrinkage, obsolescence, damage
Assets held for sale Adjust to fair values, therefore no subsequent adjustment
for impairment
Investments Adjust to either fair value or for impairment, depending

on classification of investment (refer to classification
schedule above for details)
Biological assets Adjust to fair values, therefore no subsequent adjustment

for impairment
Property, plant, and equipment Adjust for impairment
Intangible assets Adjust for impairment
Disclosures such as those listed in the classification schedule above may be presented in
parentheses beside the line item within the body of the SFP/BS, if the disclosure is not lengthy.
Otherwise, the disclosure is to be included in the notes to the financial statements and cross-
referenced to the corresponding line item in the SFP/BS.
Using parentheses tends to be more common for ASPE companies with simpler disclosure re-
quirements. IFRS companies and larger ASPE companies extensively use the cross-referencing
method because of the more complex and lengthy notes disclosures required.
Below is an example of a Statement if Financial Position. Recall that a classified SFP/BS

reports groupings of similar line items together as either current or non-current (long-term)
assets and liabilities.
ABC Company Ltd.

December 31, 2020
Assets
Current assets
Cash $ 250,000
Investments (fair value)
Accounts receivable $180,000
Allowance for doubtful accounts (2,000) 178,000
Note receivable (NRV) 15,000
Inventory (at lower of FIFO cost and NRV) 500,000
Prepaid expenses 15,000
Total current assets 958,000
Long term investments (fair value 25,000
Property, plant and equipment
Land 75,000
Building $ 325,000
Accumulated depreciation (120,000) 205,000
Equipment 100,000
Accumulated depreciation (66,000) 34,000 314,000
Intangible assets (net of accumulated
amortization for $25,000) 55,000
Goodwill 35,000
Total assets $1,387,000
Liabilities and Shareholders’ Equity

Current liabilities
Accrued interest payable 15,000
Accrued other liabilities 5,000
Income taxes payable 44,000
Unearned revenue 125,000
Total current liabilities $ 264,000
Long-term bonds payable (20-year
5% bonds, due June 20, 2029) 200,000
Total liabilities 464,000
Shareholders’ equity
Paid in capital
Preferred, ($2, cumulative, participating
– authorized, 30,000 shares; issued
and outstanding, 15,000 shares) $ 150,000
Common (authorized, 400,000 shares;
issued and outstanding 250,000 shares) 750,000
Contributed surplus 15,000 915,000
Retained earnings 8,000 923,000
Total liabilities and shareholders’ equity $1,387,000
Note that the measurement basis disclosures are in parenthesis for any assets where a
measurement other than cost is possible. Also note the interest rate and due date paren-
thetical disclosure for the long-term liability. In the equity section, the class, authorized, and
outstanding shares are disclosed.
Taking a closer look at this statement, ASPE Company reports $1,387,000 in total assets
and $464,000 in corresponding obligations against those assets owing to suppliers and other
creditors.
On the topic of debt reporting, the current portion of long-term debt is a reported as a current
liability. The current portion of the long-term debt is the amount of principal that will be paid
within one year of the SFP/BS date.
For example, on December 31, 2019, ASPE Company signed a three-year, 2%, note. Pay-
ments of $137,733 are payable each December 31. If the market rate was 2.75%, the present
value of the note would be $391,473 at the time of signing on December 31, 2019. Below is
the payments schedule of the note using the effective interest method.
Payment Interest Principal Balance

Amount @ 2.75%
December 31, 2019 $391,473
December 31, 2020 $137,733 $10,766 $126,967 264,506
December 31, 2021 137,733 7,274 130,459 134,047
December 31, 2022 137,733 3,686 134,047 0
(rounded)
If the SFP/BS date is December 31, 2020, the current portion of the long-term debt to report as
a current liability would be $130,459 from the note payable payments schedule above. Note
that this amount comes from the year following the 2020 reporting year to correspond with
the principal amount owing within one year of the current reporting date (December 31, 2020).
The total amount owing as at December 31, 2020 is $264,506; therefore, the long-term portion
of $134,047 would be the amount owing net of the current portion of $130,459. Below is how
it would be reported in the SFP/BS at December 31, 2020:
Current Liabilities
Current portion of long-term note payable $130,459
Long-term Liabilities
Note payable, 2%, three-year, due date Dec 31, 2022 $134,047
(balance owing Dec 31, 2020, of $264,506 − $130,459)
If the current portion of the long-term debt is not reported as a current liability, there will be
a material reporting misstatement that would affect the assessment of the company’s liquidity
and solvency.
Total equity of $923,000 represents the remaining assets financed by the company share-
holders. Ranking first are the preferred shareholders capital investors of $150,000. They are
usually reported before the common shares because they are senior to common shares in
terms of both dividend payouts and claims to resources if a company liquidates. However, this
is not a reporting requirement. The contributed surplus of $15,000 is additional paid-in capital
from shareholders. Examples of transactions that recognize contributed surplus include:
• stock options such as an employee stock option plan, or other share-based compensa-
tion plan and issuance of convertible debentures
• for certain share re-purchase transactions where the purchase proceeds are lower than
the assigned value of the shares
• donated assets by shareholders
• defaulted shares subscriptions
• certain related party transactions (ASPE)
If there are more line items than simply common shares, a paid-in capital subtotal is also
required for IFRS companies. Paid-in capital is the total amount “paid in” by shareholders and
therefore not resulting from ongoing operations. It is comprised of all classes of share capital
plus contributed surplus, if any. Finally, the retained earnings line item is the total net income
accumulated by the company since its inception that has not been distributed in dividends to
the shareholders.
Below are other reporting requirements:
• The statement can be prepared on a consolidated basis. This means that there are sub-
sidiaries included where the reporting company is the parent company. Subsidiaries are
investments in the shares of another company where the shares purchased are greater
than 50%. In this case, there will be a line item called “non-controlling interest” that must
be included for the portion of the subsidiary owned by other third-party investors.
• The presentation currency is stated as Canadian dollars and the level of rounding can be
to the nearest thousand dollars or million dollars, depending on the size of the company.
• The financial data is to include the previous year (an IFRS disclosure requirement).
• An accumulated other comprehensive income/loss (AOCI) is an equity account used

only by IFRS companies to accumulate items reported in OCI in the statement of com-
prehensive income. AOCI. Recall from the previous chapter that an example of an OCI
transaction would be the unrealized gains or losses from fair value adjustments while
holding certain FVOCI investments. FVOCI investments and AOCI will be covered in
detail later in this course. For now, note the position of the AOCI account in the equity
section.
4.2.2 Factors Affecting the Statement of Financial Position/Balance Sheet

(SFP/BS)
Accounting Estimates, Changes in Accounting Policy, and Correction of Errors
These were discussed in the previous chapter, but a summary of the pertinent information in
this chapter is warranted because of their impact on the SFP/BS.
Financial statements can be affected by changes in accounting estimates, changes due to

accounting errors or omissions, and changes in accounting policies. These were first intro-
duced in the introductory accounting course and will also be discussed in detail in the next
intermediate accounting course. However, it is worth including a review at this time because
of the potentially significant effect on the financial statements.
Changes in Accounting Estimates
Accounting is full of estimates that are based on the best information available at the time.
As new information becomes available, estimates may need to be changed. Examples of
changing estimates would be the useful life, residual value, or the depreciation pattern used
to match the use of assets with revenues earned. Other changes in estimates involve uncol-
lectible receivables, asset impairment losses, and pension assumptions that could affect the
accrued pension asset/liability account in the SFP/BS. Changes in accounting estimates are
applied prospectively, meaning they are applied to the current fiscal year if the accounting
records have not yet been closed and for all future years going forward.
Changes Due to Accounting Errors or Omissions
The accounting treatment for an error or omission is a retrospective adjustment with restate-
ment. Retrospective adjustment means that the company reports treat the error or omission
as though it had always been corrected. If an accounting error in inventory originating in the
current fiscal year is detected before the current year’s books are closed, the inventory error
correction is easily recorded to the current fiscal year accounts. If the accounting records are
already closed when the inventory error is discovered, the error is adjusted to the inventory
account and to retained earnings, net of taxes. This results in a restatement of inventory and
retained earnings in the current year. If the financial statements are comparative and include
previous year’s data, this data is also restated to include the error correction from the previous
year.
Changes in Accounting Policy
The accounting treatment for a change in accounting policy is retrospective adjustment with
restatement.
Examples of changes in accounting policies are:
• Changes in valuation methods for inventory such as changing from FIFO to weighted
average cost.
• Changes in financial assets and liabilities such as FVNI, FVOCI and AC investments or
certain lease obligations. Details of these are discussed in the chapter on intercorporate
investments, later in this text.
• Changes in the basis of measurement of non-current assets such as historical cost and
revaluation.
• Changes in the basis used for accruals in the preparation of financial statements.
Accounting policies must be applied consistently to promote comparability between financial

statements for different accounting periods. A change in accounting policy is only allowed
under the following two conditions:
• due to changes in a primary source of GAAP
• may be applied voluntarily by management to enhance the relevance and reliability of

information contained in the financial statements for IFRS. [ASPE has some exceptions
to this “relevance and reliability” rule to provide flexibility for changes from one existing
accounting standard to another.]
Changes in accounting policies are applied retrospectively in the financial statements. As with
accounting errors, retrospective application means that the company implements the change
in accounting policy as though it had always been applied. Consequently, the company will
adjust all comparative amounts presented in the financial statements affected by the change in
accounting policy for each prior period presented. Retrospective application reduces the risk
of changing policies to manage earnings aggressively because the restatement is made to all
prior years as well as the current year. If this were not the case, the change made to a single
year could materially affect the statement of income for the current fiscal year. A cumulative
amount for the restatement is estimated and adjusted to the affected asset or liability in the
SFP/BS and to the opening retained earnings balance of the current year, net of taxes, in the
statement of changes in equity (IFRS) or the statement of retained earnings (ASPE).
Contingencies, Provisions and Guarantees
In accounting, a contingency (ASPE) or provision (IFRS) exists when a material future event,
or circumstance, could occur but cannot be predicted with certainty. IFRS (IAS 37.10) has the
following definitions regarding the various types of contingencies in accounting (IFRS, 2015).
Key definitions [IAS 37.10]
Provision: a liability of uncertain timing or amount.
Liability:
• present obligation resulting from past events
• settlement is expected to result in an outflow of resources (payment)
Contingent liability:
• a possible obligation depending on whether some uncertain future event occurs, or
• a present obligation but payment is not probable, or the amount cannot be measured
reliably
Contingent asset:
• a possible asset that arises from past events, and
• whose existence will be confirmed only by the occurrence or non-occurrence of one

or more uncertain future events not wholly within the control of the entity.
IAS 37 explains that a contingent liability is to be disclosed in the financial statement notes.
Figure 4.1 is a decision tree that identifies the various decision points when determining if a
potential obligation should be recognized and recorded, because it meets the definition of a
liability; added only to the notes, because it meets the definition of a contingent liability; or
omitted altogether because it fails to meet any of the relevant criteria (Friedrich, Friedrich, &
Spector, 2009).
Start
Present obligation
No No
as the result of an Possible obligation?
obligation event?
Yes
Yes
No Yes
Probable outflow? Remote?
Yes
No
No (rare)
Reliable estimate?
Yes
Recognize and Disclose contingent liability

Do nothing
record as a provision in financial statement notes
Figure 4.1: Decision tree to determine if a potential obligation should be recognized and
recorded (Friedrich, Friedrich, & Spector, 2009)
IAS 37 also states that a contingent asset is not to be recorded until it is actually realized but
can be included in the notes if it is probable that an inflow of economic benefits will occur
(IFRS, 2012). If a note disclosure is made, management must take care not to mislead the
reader regarding its potential realization; if the potential asset is not probable, it must not be
disclosed.
ASPE is similar, but the provision is usually interpreted as “more likely than not” whereas a
contingent liability is one that is “likely.”
Contingencies will be discussed further in the chapter on liabilities in the next intermediate
accounting course.
A guarantee is a type of contingent liability because it is a promise to take responsibility for

another company’s financial obligation if that company is unable to do so. An example might be
a parent company that guarantees part or all of a bond issuance to investors by its subsidiary
company. Guarantees are not recognized and recorded because they are not probable, so
they are to be disclosed in the notes. This will enable investors and creditors to assess the
potential impact of the guarantee and the risk associated with it.
Subsequent Events
There is a period of time after the year-end date when economic events apparent in the new
year may need to be either reported in the financial statements for the year just ended or
disclosed in the notes prior to their release.
If this subsequent event is significant and relates to business operations prior to the reporting
date, it is to be included in the financial statements prior to release. These would include ad-
justing entries such as inventory write-downs due to shrinkage, recording additional accounts
payable for late arriving invoices from suppliers or correction of errors or omissions found when
reconciling the general ledger accounts as part of the year-end process.
If a subsequent event is significant but relates to operations occurring after the reporting
period, it is to be included in the notes. An example might be where early in the new fiscal
year, there is a flood causing serious damage to buildings and equipment, if the repair or
replacement costs are significant and perhaps uninsured, these costs, though correctly paid
and recorded in the new year, are to be disclosed in the notes to the financial statements for
the year-end just ended. This will ensure that the company stakeholders will be aware of all
the information about risks that could detrimentally affect company operations.
4.3 Statement of Cash Flows (SCF)
The last core final financial statement to discuss is the statement of cash flows. The purpose of
this statement is to provide a means to assess the enterprise’s capacity to generate cash and
to enable stakeholders to compare cash flows of different entities (CPA Canada, 2016). This
statement is an integral part of the financial statements for two reasons. First, this statement
helps readers to understand where these cash flows in (out) originated during the current year,
to assess a company’s liquidity, solvency, and financial flexibility. Second, these historic cash
flows in (out) can be used to predict future company performance.
The statement of cash flows can be prepared using two methods: the direct method and the
indirect method. Both methods organize cash flows into three activities: operating, investing,
and financing activities. The direct method reports cash flows from operating activities into
categories such as cash from customers, cash to suppliers, and cash to employees. The
indirect method reports cash flows from operating activities starting with net income/loss
adjusted for any non-cash items, followed by the changes in each of the working capital
accounts (i.e., current assets and current liabilities accounts). The total cash flows from the
operating activities are the same for both methods. The investing and financing activities are
prepared the same way under both methods.
This course will explain how to prepare the statement of cash flows using the indirect method.
The direct method will be discussed in a subsequent intermediate accounting course.
Below is a statement of cash flows that illustrates the overall format and its connections with
the income statement and SFP/BS.
4.3. Statement of Cash Flows (SCF) 97
XYZ Company Ltd.

Linkage to other financial
Cash flows from operating activities statements:
Net income (loss) $$$ or ($$$)
Non-cash items (adjusted from net income)
Depreciation, depletion and amortization expenses + $$$
Losses (gains) from sale of non-current tangible assets $$$ or ($$$)
Deferred income tax expense + $$$
Impairment losses from inventory or receivables + $$$ line items from the income
Investment income from investment in associate ($$$) statement
Investment income from investment in associates (equity ($$$)
method)1 ($$$)
Unrealized investment losses (gains) (due to +/- changes ($$$)
in their fair value)1 ($$$)
Unrealized foreign exchange losses (gains) $$$ or ($$$)
Cash in (out) from operating working capital
Decrease (increase) in trading investments $$$ or ($$$)
Decrease (increase) in accounts receivable $$$ or ($$$)
Decrease (increase) in notes receivable $$$ or ($$$)
Decrease (increase) in inventory $$$ or ($$$)
Decrease (increase) in prepaid expenses $$$ or ($$$) changes in current assets and
current liabilities from the bal-
Decrease (increase) in accounts payable $$$ or ($$$) ance sheet
Decrease (increase) in interest payable $$$ or ($$$)
Decrease (increase) in other liabilities $$$ or ($$$)
Decrease (increase) in income taxes payable $$$ or ($$$)
Decrease (increase) in unearned revenue $$$ or ($$$)
Net cash from operating activities
Sales proceeds or (purchase) of non-current investments $$$ or ($$$)
Sales proceeds or (purchase) of changes in non-current assets
property, plant, and equipment $$$ or ($$$) accounts
Sales proceeds or (purchase) of intangible assets $$$ or ($$$)
Net cash from investing activities $$$ or ($$$)
Additions to or (repayment) of long-term debt $$$ or ($$$) changes in non-current lia-
Proceeds from shares issuance $$$ or ($$$) bilities and equity accounts
Dividends paid ($$$) (share capital and dividends)
Net cash from financing activities $$$ or ($$$)
Net increase (decrease) in cash and cash equivalents $$$ or ($$$) sum of the 3 sections above
Cash and cash equivalents, January 1 $$$
Cash and cash equivalents, December 31 $$$ reconciles the net change with
opening and closing cash and
cash equivalent balances from
the balance sheet
1
Discussed in Chapter 8, Intercorporate Investments
Note that interest and dividends paid can also be reported in the operating activities section.
For the indirect method, the sum of the non-cash adjustments and changes to current assets
and liabilities represents the total cash flow in (out) from operating activities. Any non-cash
transactions relating to the investing or financing activities are excluded from the SCF but are
disclosed in the notes. An example would be an exchange of property, plant, or equipment for
common shares or a long-term note payable. The final section of the statement reconciles the
net change from the three sections with the opening and closing cash and cash equivalents
balances.
4.3.1 Preparing a Statement of Cash Flows
Presented below is the SFP/BS and income statement for Watson Ltd.
Watson Ltd.
Balance Sheet
As at December 31, 2020
2020 2019
Assets
Current assets
Cash $ 307,500 $ 250,000
Investments (trading, at fair value through net income) 12,000 10,000
Accounts receivable (net) 249,510 165,000
Notes receivable 18,450 22,000
Inventory (at lower of FIFO cost and NRV) 708,970 650,000
Prepaid insurance expenses 18,450 15,000
Total current assets 1,314,880 1,112,000
Long term investments (at amortized cost) 30,750 0
Property, plant, and equipment
Land 92,250 92,250
Building (net) 232,000 325,000
324,250 417,250
Intangible assets (net) 110,700 125,000
Total assets $1,780,580 $1,654,250
Current liabilities
Accounts payable $ 221,000 $ 78,000
Accrued interest payable 24,600 33,000
Income taxes payable 54,120 60,000
Unearned revenue 25,000 225,000
Current portion of long-term notes payable 60,000 45,000
Total current liabilities 384,720 441,000
Long-term notes payable (due June 30, 2025) 246,000 280,000
Total liabilities 630,720 721,000
Paid in capital
Preferred, ($2, cumulative, participating – authorized
issued and outstanding, 15,000 shares) 184,500 184,500
Common (authorized, 400,000 shares; issued and
outstanding (2020: 250,000 shares);
(2019: 200,000 shares) 862,500 680,300
Contributed surplus 18,450 18,450
1,065,450 883,250
1,149,860 933,250
Total liabilities and shareholders’ equity $1,780,580 $1,654,250
Watson Ltd.
Income Statement
Sales $3,500,000
Gross profit 1,400,000
Operating expenses
Salaries and benefits expense 800,000
Depreciation expense 43,000
Travel and entertainment expense 134,000
Advertising expense 35,000
Freight-out expenses 50,000
Supplies and postage expense 12,000
Telephone and internet expense 125,000
Legal and professional expenses 48,000
Insurance expense 50,000
1,297,000
Income from operations 103,000
Other revenue and expenses
Dividend income 3,000
Interest income from investments 2,000
Gain from sale of building 5,000
Interest expense (3,000)
7,000
Income from continuing operations before income tax 110,000
Income tax expense 33,000
Net income $ 77,000
1. The trading investment does not meet the criteria to be classified as a cash equivalent
and no purchases or sales took place in the current year.
2. An examination of the intangible assets sub-ledger revealed that a patent had been sold
in the current year. The intangible assets have an indefinite life.
3. No long-term investments were sold during the year.
4. No buildings or patents were purchased during the year.
5. Most of the unearned revenues occurred on December 31, 2019.
6. There were no other additions to the long-term note payable during the year.
7. Common shares were sold for cash. No other transactions occurred during the year.
8. Cash dividends were declared and paid.

The statement of cash flows can be challenging to prepare. This is because preparing the
entries requires analyses of the accounts as well as an understanding of the types of trans-
actions that affect each account. Preparing a statement of cash flows is made much easier if
specific steps in a sequence are followed. Below is a summary of those steps.
1. Complete the statement headings.
2. Record the net income/loss in the operating activities section.
3. Adjust for any non-cash line items reported in the income statement to restate net
income/loss from an accrual to a cash basis (i.e., depreciation expense, amortization
expense and any non-cash gains or losses).
4. Record the description and change amount as cash inflows or outflows for each current
asset and current liability (working capital accounts) except for the “current portion of
long-term debt” line item, since it is not a working capital account. Subtotal the operating
activities section.
5. In the investment activities section, using T-accounts or other techniques, determine the
change for each non-current (long-term) asset account. Analyze and determine the
reasons for the change. Record a description and the change amount(s) as cash inflows
or outflows.
6. In the financing activities section, add back to long-term debt any current portion identi-
fied in the SFP/BS for both years, if any. Using T-accounts or other techniques, determine
the change for each non-current liability and equity account. Analyze and determine
the reason for the change(s). Record a description and the change amount(s) as cash
inflows or outflows.
7. Subtotal the three sections and record as the net change in cash. Record the opening
and closing cash and cash equivalents balances. Sum the opening balance, the new
change in cash subtotal, and the closing balance. This should to reconcile with the
ending cash and cash equivalent balances from the SFP/BS.
8. Complete any required disclosures.
To summarize the steps above into a few key words and phrases to remember:
Headings
Record net income/(loss)
Adjust out non-cash income statement items
Current assets and current liabilities changes
Non-current asset accounts changes
Non-current (long-term) liabilities and equity accounts changes
Subtotal and reconcile
Disclosures
Applying the Steps:
1. Headings:
Watson Ltd.

Net income (loss)
Non-cash items (adjusted from net income):

Net cash from investing activities

Net cash from financing activities

Net increase (decrease) in cash
Cash, January 1
Cash, December 31
2. Record net income/(loss)

As illustrated in step 3 below.
3. Adjustments:
Watson Ltd.
Income Statement
Sales $3,500,000
Operating expenses
Salaries and benefits expense 800,000
Travel and entertainment expense 134,000
Advertising expense 35,000
Freight-out expenses 50,000
Supplies and postage expense 12,000
Telephone and internet expense 125,000
Legal and professional expenses 48,000
Insurance expense 50,000
1,297,000
Other revenue and expenses
Dividend income 3,000
Interest income from investments 2,000
Gain from sale of building 5,000
Interest expense (3,000)
7,000
Net income $ 77,000
Watson Ltd.

Net income (loss) $ 77,000
Gain from sale of equipment (5,000)
Enter the amount of the net income/(loss) as the first amount in the operating activities
section. Next, review the income statement and select the non-cash items. Look for
items such as depreciation, depletion, amortization, and gain/loss on sale/disposal of
assets. In this case, there are two non-cash items to adjust. Record them as adjustments
to net income in the statement of cash flows.
4. Current assets and liabilities:

Calculate and record the change for each current asset and current liability (except the
current portion of long-term notes payable, which is to be included with its corresponding
long-term notes payable account) as shown in the financing activities section below:
Watson Ltd. Accounting Equation:

for the year ended December 31, 2020 A = L + E MUST ALWAYS BALANCE!
Gain from sale of building (5,000) Cash + (all other) Assets = Liabilities + Equity
Cash in (out) from operating working capital:

Increase in trading investments (2,000)
Increase in accounts receivable (84,510)
Decrease in notes receivable 3,550 Cash + Assets = Liabilities + Equity
Increase in inventory (58,970)
Increase in prepaid expenses (3,450)
Increase in accounts payable 143,000
Cash + Assets = Liabilities + Equity
Decrease in interest payable (8,400)
Decrease in income taxes payable (5,880)
Decrease in unearned revenue (200,000) Cash + Assets = Liabilities + Equity
Net cash from operating activities (101,660)
Cash inflows are reported as positive numbers, while cash outflows are reported as
negative numbers. To determine if the amount is a positive or negative number, a simple
method is to use the accounting equation to determine whether cash is increasing as a
positive number or decreasing as a negative number.
Recall that the accounting equation, Assets = Liabilities + Equity, must always remain
in balance. This concept can be applied when analyzing the various accounts and
recording the changes. For example, accounts receivable has increased from $165,000
to $249,510 for a total change of $84,510. Using the accounting equation, this can be
expressed as:
Expanding the A = L + E equation a bit:
Cash + accounts receivable + all other assets = Liabilities + Equity
If accounts receivable increases by $84,510, this can be expressed as a black up-arrow

above the account in the equation:
If accounts receivable increases, its effect on the cash account must be a corresponding
decrease to keep the equation balanced:
If cash decreases, it is a cash outflow, and the number must be negative (bracketed) as
shown in the statement above.
The same technique can be used when analyzing liability or equity accounts. For
example, an increase in account payable (liability) of $143,000 will affect the equation as
follows:
Cash + all other assets = Liabilities + Equity
If accounts payable increases, cash must also increase by a corresponding amount in

order to keep the equation in balance.
Cash + all other assets = Liabilities + Equity
If cash increases, it is a cash inflow and the number must be positive (no brackets) as
shown in the statement above.
5. Non-current asset changes:

The next section is the investing activities section. The analysis of all the non-current
asset accounts must also take into account whether there have been any current year
purchases or disposals/sales (or both) as part of the analysis. The use of T-accounts for
this type of analysis provides a useful visual tool to help understand the changes that
occurred in the account.

Investments (trading, FVNI) (30,750) Cash + Assets = Liabilities + Equity
Sales proceeds from sale of building 55,000
Sales proceeds from sale of patent 14,300
Net cash from investing activities 38,550 Cash + Assets = Liabilities + Equity
There are four non-current asset accounts: long-term investments, land, buildings, and
intangible assets. The land account had no change so there were no purchases or sales
of land. Analyzing the investment account results in the following cash flows:
Long-term investment
–
?? = purchase of investment
30,750
Since the additional information presented above stated that there were no sales of long-term investments
during the year, the entry would have been for a purchase:
General Journal
Long term investments (at amortized cost) . . . . . 30,750
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,750
Cash paid for the investment was therefore $30,750.
Analysis of the buildings account is a bit more complex because of the effects of the
contra account for accumulated depreciation. In this case, the building account and its
contra account must be merged since the SFP/BS reports only the net carrying amount.
Analyzing the buildings account results in the following cash flows:
Building (net of accum. depr.)

325,000
43,000 current year accum. depr.
?? = sale of building
232,000
Building (net of accum. depr.)

325,000
43,000
50,000 =X
232,000
Since there was a gain from the sale of buildings, the entry would have been:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,000
Gain on sale of building . . . . . . . . . . . . . . . . . . . . 5,000
Buildings (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
Cash proceeds were therefore $55,000.
The sale of the patent is straightforward since there were no other sales or purchases in
the current year.
6. Non-current liabilities and equity changes:
Net cash from investing activities 38,550

Cash flows from financing activities Cash + Assets = Liabilities + Equity
Repayment of long-term note (19,000)
Proceeds from shares issuance 182,200
Net cash from financing activities 120,610 Cash + Assets = Liabilities + Equity
There are five long-term liability and equity accounts: long-term notes payable, preferred
shares, common shares, contributed surplus, and retained earnings. The preferred
shares and contributed surplus accounts had no changes to report. Analyzing the long-
term note payable account results in the following cash flows:
Long-term note payable

280,000
45,000
?? = repayment
246,000
60,000
Since there were no other transactions stated in the additional information above, the entry would have
been:
General Journal
LT note payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,000
Cash paid was therefore $19,000.
Note how the current portion of long-term debt has been included in the analysis of the
long-term note payable. The current portion line item is a reporting requirement regard-
ing the principal amount owing one year after the reporting date, but it is not actually
a working capital account, so it is omitted from the operating section and included with
its corresponding long-term liability account in the financing activities section as shown
above.
The common shares and retained earnings accounts are straightforward and the analy-
sis of each are shown below.
Common shares
680,300
?? = share issuance
862,500
Since there were no other transactions stated in the additional information above, the entry would have
been:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182,200
Common shares . . . . . . . . . . . . . . . . . . . . . . . . . . . 182,200
Cash received was therefore $182,200.
Retained earnings
50,000
77,000 net income
?? = dividends paid
84,410
The additional information stated that cash dividends were declared and paid, so the entry would have been:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,590
Cash paid was therefore $42,590.
7. Subtotal and reconcile:

The three activities total a net increase in cash of $57,500. When added to the opening
cash balance of $250,000, the resulting total of $307,500 is equal to the ending cash bal-
ance, December 31, 2020 in the SFP/BS. This can be seen in the completed statement
below.
4.3.2 Disclosure Requirements
Step 8 involves the identification and preparation of disclosures.
8. Required disclosures:
The statement of cash flows must disclose cash flows associated with interest paid and
received, dividends paid and received, and income taxes paid, as well as any non-cash
transactions that occurred in the current year. These can be disclosed in the notes or at
the bottom of the statement, if not too lengthy. The cash received for dividend income
and interest income was taken directly from the income statement since no accrual
accounts exist on the SFP/BS for these items. Cash paid for interest charges and income
taxes are calculated based on an analysis of their respective liability accounts from the
SFP/BS and expense accounts from the income statement.
Following is the completed statement of cash flows, including disclosures, for Watson
Ltd., for the year ended December 31, 2020:
Watson Ltd.

Gain from sale of equipment (5,000)
Cash in (out) from operating working capital:

Increase in trading investments (2,000)
Decrease in notes receivable 3,550
Increase in prepaid expenses (3,450)
Increase in accounts payable 143,000
Decrease in interest payable (8,400)
Decrease in income taxes payable (5,880)
Decrease in unearned revenue (200,000)
Net cash from operating activities (101,660)
Purchase of AC investments (30,750)
Sales proceeds from sale of building 55,000
Sales proceeds from sale of patent 14,300
Net cash from investing activities 38,550
Repayment of long-term note (19,000)
Proceeds from shares issuance 182,200

Net cash from financing activities 120,610
Net increase (decrease) in cash 57,500
Cash, January 1 250,000
Cash, December 31 $ 307,500
Disclosures:
Cash paid for income taxes $38,880
(60,000 + 33,000 − 54,120)
Cash paid for interest charges 11,400
(33,000 + 3,000 − 24,600)
Cash received for interest income 2,000
Cash received for dividend income 3,000
[There were no non-cash transactions to disclose.]

4.3.3 Interpreting the Statement of Cash Flows
The cash balance shows an increase of $57,500 from the previous year. Without looking
deeper into the reasons why, a hasty conclusion could be drawn that all is well with Watson
Ltd. However, there is trouble ahead for this company. For example, the operating activities
section, which represents the reason for being in business, is in a negative cash flow position.
The profit that a company earns is expected to result in positive cash flows, and this positive
cash flow should be reflected in the operating activities section. In this case, it does not, since
there is a negative cash flow of $101,660 from operating activities. Why?
For Watson, both the accounts receivable and inventory have increased, resulting in a net
decrease in cash of $143,480. An increase in accounts receivable may mean that sales have
occurred, but the collections are not keeping pace with the sales on account. An increase
in inventory may be because there have not been enough sales in the current year to cycle
the inventory from a current asset to sales/profit and ultimately into cash. The risk of holding
large amounts of inventory is the increased possibility that inventory will become obsolete or
damaged and unsellable.
In this case, an additional reason for decreased net cash from operating activities is due to a
decrease in unearned revenue. This is an interesting issue that needs to be explained more
fully. Recall that unearned revenue is cash received from customers in advance of earning
the revenue. In this case, the cash would have been reported as a positive cash flow in
the operating activities section in the previous reporting period when the cash was actually
received. At that time, the cash generated from operating activities would have increased by
the amount of the cash received for the unearned revenue. The entry upon receipt of the cash
would have been:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225,000
Unearned revenue . . . . . . . . . . . . . . . . . . . . . . . . . 225,000
When the company provides the goods and services to the customer, the net income reported
at the top of the operating section will reflect that portion of the unearned revenue that is now
earned. However, it did not obtain actual cash for this revenue in this reporting period because
the cash was already received in the prior reporting period. Keep in mind that unearned
revenue is not normally an obligation that must be paid in cash to the customer. Once the
goods and services are provided to the customer, the obligation ceases.
Looking at the investing activities, there was a sale of a building and a purchase of a long-
term investment. The sales proceeds from the building may have been partially invested in
the investment to make a return on the cash proceeds until it can be used for its intended
purpose in the future. Again, more analysis is necessary to confirm whether this is the case.
The sale of the patent also generated a positive cash flow. There was no gain on sale of the
patent reported in the income statement, so the sales proceeds did not exceed its carrying
value at the time it was sold. Hopefully, the patent sale was not the result of a panic sale to
raise additional cash.
Looking at the financing activities the majority of cash inflows for this reporting period resulted
from the issuance of additional common shares of $182,200. This represents an increase in
the share capital of greater than 25%. Increased shares will have a negative impact on the
earnings per share and possibly its market price as well, which may send warning signals to
investors. The shareholders were also paid dividends of $42,590, but this amount only barely
covers the preferred shareholders dividend of $30,000 (15,000 × $2) plus its share of the
participating dividend. This leaves very little dividend left over for the common shareholders.
At some point, the common shareholders will likely become concerned with receiving so little in
dividends, along with the dilution of their shareholdings due to the large issuance of additional
shares.
When looking at the opening and closing cash balances for Watson, these seem like sizeable
balances, but what matters is where the cash came from and whether those sources are
sustainable. The $250,000 opening balance was almost entirely due to the $225,000 unearned
revenue received in advance, but this is likely not a sustainable source. The ending cash
balance of $307,500 is due to the issuance of additional share capital of $182,200 (possibly a
one-time transaction) and an increase in accounts payable of $143,000 that must be paid soon.
Consider that during the year, the cash from the unearned revenues was being consumed and
the issuance of the additional capital had not yet occurred. It would be no surprise, if cash at
the mid-year point was insufficient to cover even the short-term liabilities, hence the increase
in accounts payable and ultimately the issuance of additional capital shares.
Watson is currently unable to generate positive cash flows from its operating activities. The
unearned revenue of $225,000 at the start of the year added some needed cash early on,
but this reserve was depleted by the end of the reporting year. In the meantime, without a
significant change in how the company manages its inventory and receivables, Watson may
continue to experience a shortage of cash from its operating activities. To compensate, it may
continue to sell off assets, issue more shares, or incur more long-term debt to obtain needed
cash. In any case, these sources will dry up eventually when investors are no longer willing to
invest, creditors are no longer willing to loan cash, and no assets worth selling remain. This
current negative cash position from operating activities for Watson Ltd. is unsustainable and
must be turned around quickly for the company to remain a going concern.
Not all companies who report profits are financially stable. This is because profits do not
translate on a one-to-one basis with cash. Watson reported a $77,000 net income (profit), but
it is currently experiencing significant negative cash flows from its operating activities.
If sufficient cash is generated from operating activities, the company will not have to increase
its debt, issue shares, or sell off useful assets to pay their bills. For Watson Ltd., it increased its
short-term debt (accounts payable), sold off a building, and issued 25% more common shares.
4.4. Analysis 113
Perhaps Watson’s negative cash flow from operating activities will turn itself around in the
next reporting period. This would be the company’s best hope. For other companies who
experience positive cash flows from operations, they must also ensure that this is sustainable
and can be repeated consistently in the future.
4.4 Analysis
Statement of Financial Position/Balance Sheet (SFP/BS)
The SFP/BS is made up of many line items, comprised of many general ledger accounts,
using different measurement bases (historical cost, fair value, and other valuation methods
previously discussed in this chapter), and with significant adjusting entries for accruals and
application of the company’s accounting policies. For this reason, the SFP/BS does not
present a clear-cut, definitive report of a company’s exact financial state. Its purpose is to
provide an overview as a starting point for further analysis. Some types of analysis typically
undertaken by management are discussed below.
Comparative SFP/BS
Arranging previous reporting data beside the current data is a useful tool with which to analyze
trends. Some companies also include the percentage change for each line item to allow certain
changes in amounts to become highly visible. This enables analysts to narrow down possible
areas of poor performance where further investigation will be undertaken to determine the
reasons why.
Ratio Analyses
Ratio analysis is simply where relationships between selected financial data (presented in the
numerator and denominator of the formula) provide key information about a company. Ratios
from current year financial statements may be more useful when they are used to compare
with benchmark ratios. Examples of benchmark ratios are ratios from other companies, ratios
from the industry sector the company operates in, or historical and future ratio targets set by
management as part of the company’s strategic plan.
Care must be taken when interpreting ratios, because companies within an industry sector
may use different accounting policies that will affect the comparison of ratios. In the end, ratios
are based on current and past performance and are merely indicators. Further investigation
is needed to gather more business intelligence about the reasons why certain variances are
occurring.
Below are some common ratios used to analyze the SFP/BS and SCF financial statements:
Ratio Formula Purpose
Liquidity ratios – ability to pay short term obligations
Current assets
Current ratio ability to pay short term
Current liabilities
debt
Cash*, marketable securities and net receivables

Quick ratio (or acid test ratio) ability to pay short term
Current liabilities
debt using near-cash as-
sets
* Cash includes cash equivalents, if any.
Activity ratios – ability to effectively use assets
Net sales
Accounts receivable turnover how quickly accounts receivable is col-
Average net accounts receivable
lected
365
In days average # of days to collect accounts
Accounts receivable turnover
receivable
Accounts receivable
Days’ sales uncollected × 365 average # of days that sales are uncol-
Net sales
lected (this can be compared to the credit
terms of the company)
Cost of goods sold

Inventory turnover how quickly inventory is sold
Average inventory
365
In days average number of days to sell inventory
Inventory turnover
Ending inventory
Days’ sales in inventory × 365 average # of days for inventory to convert
Cost of Goods Sold
to sales
Net sales
Asset turnover the ability of assets to generate sales
Average total assets
4.4. Analysis 115
Profitability ratios – ability to generate profits
Net income
Return on total assets × 100% overall profitability of assets
Average total assets
Return on common Net income − Preferred dividends

× 100% overall profitability of common
shareholders’ equity Average common shareholders’ equity
shareholders’ investment
(includes retained earnings/deficit)
Net income − Preferred dividends

Earnings per share net income for each common
Weighted average common
share
shares outstanding (WACS)
Cash dividends
Payout ratio × 100% percentage of earnings dis-
Net income
tributed as dividends
Coverage – ability to pay long-term obligations
Total liabilities
Debt ratio × 100% percentage of assets provided
Total assets
by creditors
Total equity
Equity ratio × 100% percentage of assets provided
Total assets
by investors

Cash debt coverage ratio × 100% the ability to pay debt from net
Average total liabilities
cash from operating activities
(statement of cash flows)
Common shareholders’ equity

Book value per common share the amount per common
# of common shares outstanding
share if company liquidated at
reported amounts.
Many of the ratios identified above will be illustrated throughout the remaining chapters of this
course.
Note that ratios are not particularly meaningful without historical trends or industry standards.
Some general benchmarks signifying a reasonably healthy financial state are:
Current ratio 2:1

Quick ratio 1:1
Days’ sales uncollected 1.3 times the credit policy in days
For example, if the credit policy were 30 days, a reasonable day’s sales uncollected ratio would
be 30 days × 1.3 = 39 days that a sale would remain uncollected.
Inventory turnover 5 times per year (or in days, every 365 ÷ 5 = 73 days)
Again, it is important to understand that the general benchmarks identified above are guide-
lines only. Industry standard ratios are superior in every way, if available, since ratios are only
as good as what they are being compared to (the benchmark). If the comparative ratio is
not accurate for that industry, the analysis will be meaningless. (This is often referred to as
“garbage in; garbage out.”) As a result, management can make incorrect decisions on that
basis, seriously impairing a company’s potential future performance and sustainability.
Below are the ratio calculations for Watson Ltd. as at December 31, 2020, based on the
financial data presented in the previous section of this chapter. The material in this chapter
is intended as a high-level review. In-depth discussions are included in the introductory
accounting course, and students are encouraged to review that material at this time, if needed.
Ratio Formula Calculation Results
Liquidity ratios – ability to pay short term obligations
Current assets 1,314,880

Current ratio = 3.42 to 1 reasonable
current liabilities 384,720
Cash, marketable securities

and net receivables 307,500 + 12,000 + 249,510 + 18,450
Quick ratio (or reasonable
Current liabilities 384,720
acid test ratio) = 1.53 to 1
Activity ratios – ability to effectively use assets
Net sales 3,500,000

Accounts receivable turnover = 16.89 times / year reasonable
Average net accounts receivable ((249,510 + 165,000) ÷ 2)
365 365
In days = every 21 days reasonable
Accounts receivable turnover 16.89

Days’ sales uncollected × 365 × 365 = 26 days reasonable, given the typical
Net sales 3,500,000
credit policy of net 30 days

Inventory turnover = 3.09 times this would be low, if the industry
Average inventory ((708,970 + 650,000) ÷ 2)
standard is around 5 times
365 365
In days = every 118 days possibly too low if standard is 5
Inventory turnover 3.09
times or every 73 days
Ending inventory 708,970

Days’ sales in inventory × 365 × 365 = 123 days the total # of days to sell inven-
Cost of Goods Sold 2,100,000
tory and collect the cash from
accounts receivable is 123 + 26
= 149 days
Net sales 3,500,000

Asset turnover = 2.04 depends on industry average
Average total assets ((1,780,580 + 1,654,250) ÷ 2)
and company trends
4.4. Analysis
117
118
Profitability ratios – ability to generate profits
Financial Reports – Statement of Financial Position and Statement of Cash Flows

Net income 77,000
Return on total × 100% = 4.48% depends on industry
Average total assets ((1,780,580 + 1,654,250) ÷ 2)
assets average and
company trends
Net income − Preferred dividends (77,000 − 30,000)

Return on common × 100% = 5.48% depends on industry
Average common shareholders’ equity ((862,500 + 18,450 + 84,410 +
shareholders’ equity average and
(includes retained earnings/deficit) 680,300 + 18,450 + 50,000) ÷ 2)
company trends
Net income − Preferred dividends (77,000 − 30,000)

Earnings per share = $20.89 per share depends on industry
Weighted average common 225,000
average and
shares outstanding (WACS)
WACS (250,000 + 200,000) ÷ 2 = 225,000 company trends
shares assuming that sale of the shares
occurred mid year
Cash dividends 42,590

Payout ratio × 100% × 100% = 55.3% depends on industry
Net income 77,000
average and
company trends
Coverage – ability to pay long-term obligations

Debt ratio × 100% × 100% = 35.42% low
Total assets 1,780,580
1,149,860
= 64.58%
1,780,580
Total equity
Equity ratio × 100% OR high
Total assets
100% − 35.42% debt ratio
= 64.58%
Net cash provided by operating activities 101,660

Cash debt coverage ratio × 100% = (15.04%) unfavourable due to
Average total liabilities ((630,720 + 721,000) ÷ 2)
negative cashflow from
operating activities
Common shareholders’ equity (862,500 + 18,450 + 84,410)

Book value per common = $3.86 depends on industry
# of shares outstanding 250,000
share average and company
trends and assumes no
preferred shares
dividends are in arrears
4.4. Analysis
119
Cash Flow Ratio
It is critical to monitor the trends regarding cash flows over time. If trends are tracked, ratio
analyses can be a powerful tool to evaluate a company’s cash flows. Below are some of the
cash flow ratios currently used in business:

Liquidity ratios – ability to pay short term obligations:
Net cash flow from operating activities

Current cash debt coverage ratio ability to pay short term debt
Average current liabilities
from its day-to-day operations. A
ratio of 1:1 is reasonable.
Financial flexibility – ability to react to unexpected expenses and investment opportunities:
Net cash flow from operating activities

Cash debt coverage ratio the ability to pay debt from net
Average total liabilities
cash from operating activities
(statement of cash flows)
Free Cash Flow Analyses
Free cash flow is the remaining cash flow from the operating activities section after deduct-
ing cash spent on capital expenditures such as purchasing property, plant, and equipment.
Some companies also deduct cash paid dividends. The remaining cash flow represents cash
available to do other things, such as expand operations, pay off long-term debt, or reduce
the number of outstanding shares. Below is the calculation using the data from Watson Ltd.
statement of cash flows:
Watson Ltd.
Free Cash Flow
December 31, 2020
Cash flow provided by operating activities $(101,660)
Less capital expenditures 0
Dividends $ (42,590)
Free cash flow $(144,250)
It is no surprise that Watson has no free cash flow and no financial flexibility, since its operating
activities are in a negative position. Note that the dividend deduction in the free cash flow
calculation is optional, since dividends can be waived at management’s discretion. In Watson’s
case, it met its current year dividend cash requirements by selling more common shares to
raise additional cash. The capital expenditures should be for those relating to daily opera-
tions that are intended to sustain ongoing operations. For this reason, capital expenditures
purchased as investments are usually excluded from the free cash flow analysis.
Chapter Summary 121
Chapter Summary
LO 1: Describe the statement of financial position/balance sheet (SFP/BS) and the

statement of cash flows (SCF), and explain their role in accounting and business.
The statement of financial position (IFRS) also known as the balance sheet (ASPE) reports on
what resources the company has (assets) at a specific point in time and what claims to those
resources exist (liabilities and equity). The statement provides a way to assess a company’s
liquidity and solvency – both together creating a picture of the company’s financial flexibility.
The structure of the SFP/BS follows the basic accounting equation: A = L + E, where assets
are presented first, followed by liabilities and equity, which together equal the total assets. Key
issues are the recognition and valuation used for each account reported.
The statement of cash flows reports on how the company obtains and utilizes its cash flows
and reconciles with the cash balance reported in the SFP/BS. It is separated into operating,
investing, and financing activities. The combination of positive and negative cash flows from
each activity can provide important information about how the company manages its cash
flows.
LO 2: Explain the purpose of the SFP/BS and prepare a SFP/BS in good form.
The classified SFP/BS separates the assets and liabilities into current and non-current (long-
term) subsections based on meeting certain criteria. The statement has many disclosure
requirements that ensure it is faithfully representative, that the business continues as a going
concern, and that revenue and expenses are grouped into appropriate classifications that
meet the standards for disclosure. Some of the more common required disclosures are listed,
including the measurement basis of each account, such as cost, net realizable value, fair value,
and so on. The acceptable options regarding how to present the required disclosures include
using parentheses in the body of the statement or disclosing in the notes to the financial
statements.
Several factors influence what is reported in the SFP/BS. Included are changes in accounting
estimates that are applied prospectively and changes due to errors or omissions or accounting
policy that are applied retroactively with restatement. Descriptions of these are to be included
in the notes with detailed explanations. Other factors that can affect the SFP/BS are provi-
sions, contingencies and guarantees that may need to be recognized within the statement
or disclosed in the notes. Certain subsequent events will also affect what is reported in the
SFP/BS.
LO 3: Explain the purpose of the statement of cash flows and prepare a SCF in
good form.
The statement of cash flows (SCF) provides the means to assess the business’s capac-
ity to generate cash and to determine where the cash flows come from. The statement
combines with the SFP/BS to evaluate a company’s liquidity and solvency; when combined,
these represent a company’s financial flexibility. This information can be used to predict
the future financial position and cash flows of the company based on past events. The
SCF can be prepared using either the direct or indirect method. Regarding the indirect
method, the statement is presented in three distinct sections, which follow the basic structure
of the balance sheet classifications: operating activities (current assets, and current liabilities),
investing activities (non-current assets), and financing activities (long-term debt and equity).
The changes between the opening and closing balances of the SFP/BS accounts are reported
in the SCF as either cash inflows or cash outflows. The three sections net to a single net cash
change amount that, when combined with the cash and cash equivalent opening balances,
results in the same amount as the ending balances reported in the SFP/BS.
An important section in the SCF is the operating activities section because it reports the cash
flows resulting from daily operations which is the reason why the company is in business.
If cash flows are negative in this section, management must determine if this is due to a
temporary condition or if fundamental changes are needed to better manage activities such
as the collections of accounts receivables or levels of unsold inventory. If a company is in a
negative cash flow position from operating activities, it will usually either increase its debt by
borrowing, increase its equity by issuing more shares, or sell off some of its assets. If these
activities are undertaken, they will be detected as cash inflows from either the investing or
financing sections. None of these three options are ideal and can be done in the short run, but
they cannot be sustained in the long run. Even positive cash flows from operating activities
must be evaluated to determine if they are sustainable and will continue into the future.
LO 4: Identify and describe the types of analysis techniques that can be used for
the statement of financial position/balance sheet and the statement of cash flows.
Several analytical techniques can be applied when reviewing the SFP/BS. For example, com-
parative years’ data can be presented to help identify trends. Using a percentage for each
line item will help highlight items that may possess unusual characteristics for further analysis.
Ratio analysis is the most often used technique but is of limited value if no benchmarks such as
historical ratios or industry standards exist. Ratios typically focus on an aspect of a company
such as liquidity, profitability, effectiveness of assets used, and ability to service short- and
long-term debts. Care must be taken when interpreting the results of ratio analysis, and man-
agement must be aware that differences in ratios from competitors’ financial statements can
result from changes in accounting policies or the application of different accounting estimates
and methods.
Exercises 123
Another technique called free cash flow analysis calculates the remaining cash flow from the
operating activities section after deducting cash spent on capital expenditures such as pur-
chasing property, plant, and equipment. Some companies also deduct cash paid as dividends.
The cash flow remaining is available to use for expansion, repayment of long-term debt, or
down-sizing shareholdings to improve the share price, reduce the amount of dividends to pay,
and to attract investors.
References
Accounting-Simplified.com (n.d.). IAS 8 changes in accounting policy. Retrieved from http://

accounting-simplified.com/standard/ias-8/changes-in-accounting-policies.html
Fox, J. (2014, October 20). At Amazon it’s all about cash flow. Harvard Business Review.
Retrieved from http://blogs.hbr.org/2014/10/at-amazon-its-all-about-cash-flow/
Friedrich, B., Friedrich, L., & Spector, S. (2009). International accounting standard 37 (IAS 37),
provisions, contingent liabilities and contingent assets. Professional Development Network.
Retrieved from https://www.cga-pdnet.org/Non_VerifiableProducts/ArticlePublica
tion/IFRS_E/IAS_37.pdf
IFRS. (January, 2012). IAS 37 Provisions, Contingent Liabilities and Contingent Assets, IFRS
2012, IAS 37, para. 31–35. (2012, Jan.). [Technical summary]. Retrieved from http://www.
ifrs.org/IFRSs/IFRS-technical-summaries/Documents/IAS37-English.pdf
IFRS. (2015). International Financial Reporting Standards 2014: IAS 37 provisions, contingent
liabilities and contingent assets. London, UK: IFRS Foundation Publications Department.
Exercises
EXERCISE 4–1
Using the classification codes identified in brackets below, identify where each of the accounts
below would be classified:
Current assets (CA) Non-current liabilities (NCL)

Long-term investments (LI) Share Capital (Cap)
Property, plant, and equipment (PPE) Contributed surplus (CS)
Intangible assets (IA) Retained earnings (RE)
Accumulated other comprehensive income (AOCI) Current liabilities (CL)
Account name Classification

Preferred shares
Franchise agreement
Salaries and wages payable
Accounts payable
Buildings (net)
Investment – Held for Trading
Current portion of long-term debt
Allowance for doubtful accounts
Accounts receivable
Bond payable (maturing in 10 years)
Notes payable (due next year)
Office supplies
Mortgage payable (maturing next year)
Land
Bond sinking fund
Inventory
Prepaid insurance
Income tax payable
Cumulative unrealized gain or loss from an OCI investment
Investment in associate
Unearned subscriptions revenue
Advances to suppliers
Unearned rent revenue
Copyrights
Petty cash
Foreign currency bank account or cash
EXERCISE 4–2
Below is a statement of financial position as at December 31, 2021, for Aztec Artworks Ltd.,
prepared by the company bookkeeper:
Exercises 125
Aztec Artworks Ltd.

Current assets
Cash (including a bank overdraft of $18,000) $ 225,000
Inventory (FIFO) 960,000
Investments (trading) 140,000

Construction work in progress 220,000
Building (net) 1,500,000
Equipment (net) 380,000
Land 420,000
Intangible assets
Goodwill 190,000
Investment in bonds 200,000
Patents (net) 21,000
Current liabilities
Accounts payable 450,000
Pension obligation 210,000
Rent payable 120,000
Long-term liabilities
Preferred shares 900,000
Additional information as at December 31, 2021:
1. Cash is made up of petty cash of $3,000, a bond sinking fund of $100,000, and a bank
overdraft of $18,000 held at a different bank than the bank account where the cash
balance is currently on deposit.
2. Accounts receivable balance of $285,000 includes:
Credit balances to be cleared in 90 days 35,000

The company considers the credit balance to be significant.

3. Inventory ending balance does not include inventory costing $20,000 shipped out on
consignment on December 30, 2021. The company uses FIFO cost formula and a
perpetual inventory system.
The net realizable value of the inventory at year-end is:
Inventory, December 31 $960,000

Inventory on consignment 25,000
4. Investments are held for trading purposes. Their fair value at year-end is $135,000.
5. The accumulated depreciation account balance for buildings is $450,000 and $120,000
for equipment. The construction work-in-progress represents the costs to date on a new
building in the process of construction. The land where the building is being constructed
was purchased of $220,000. The remaining land is being held for investment purposes.
6. Goodwill of $190,000 was included in the accounts when management decided that their
product development team has added significant value to the company.
7. The investment in bonds is being held to maturity in 2030, and is accounted for using
amortized cost.
8. Patents were purchased by Aztec on January 1, 2019, at a cost of $30,000. They are
being amortized on a straight-line basis over 10 years.
9. Income tax payable of $80,000 was accrued on December 31 and included in the ac-
counts payable balance.
10. The notes payable are due June 30, 2022. The principal is not due until then.
11. The pension obligation is considered by the auditors to be a long-term liability.
12. The 20-year bonds payable bear interest at 5% and are due August 31, 2025. The
bonds’ annual interest was paid on December 31. The company established the bond
sinking fund that is included in the cash balance.
13. For common shares, 900,000 are authorized and 700,000 are issued and outstanding.
The preferred shares are $2, non-cumulative, participating shares. Fifty thousand are
authorized and 20,000 are issued and outstanding.
14. Net sales for the year are $3,000,000 and gross profit is 40%.
Required:
a. Prepare a corrected classified SFP/BS as at December 31, 2021, in good form, including
all required disclosures identified in Chapter 4. Adjust the account balances as required
based on the additional information presented.
Exercises 127
b. Calculate one liquidity ratio and one activity ratio and comment on the results. Use
ending balances in lieu of averages when calculating ratios.
EXERCISE 4–3
Below is the trial balance for Johnson Berthgate Corp. at December 31, 2021. Accounts are
listed in alphabetical order and all have normal balances.
Account Balance
Accrued liabilities 70,000
Accumulated depreciation, buildings 110,000
Accumulated depreciation, equipment 50,000
Administrative expenses 580,000
Bonds investment at amortized cost 190,000
Buildings 660,000
Cash 131,000
Commission payable 90,000
Correction of prior year’s error – a missed expense in 2020 (net of tax) 90,000
Equipment 390,000
Freight-out 11,000
Goodwill 30,000
Intangible assets, franchise (net) 115,000
Intangible assets, patents (net) 125,000
Inventory 440,000
Investment (available for sale) 180,000
Investment (trading) 100,000
Land 170,000
Notes payable (due in 6 months) 60,000
Preferred shares 80,000
Prepaid advertising 6,000
Selling expenses 1,190,000
Unearned consulting fees 13,000
Unrealized gain on trading investments 40,000
Unusual gain 102,000
1. Inventory has a net realizable value of $430,000. The weighted average cost method of
inventory valuation was used.
2. Trading investments are securities held for trading purposes and have a fair value of
$120,000. Investments in bonds are being held to maturity at amortized cost with interest
payments each December 31. Investments in other securities are classified as available
for sale (FVOCI) and any gains or losses will be recognized through other comprehensive
income (OCI). These have a fair value of $180,000 at the reporting date.
3. Correction of the prior period error relates to a missed travel expense from 2020. The
books are still open for 2021.
4. Patents and franchise were being amortized on a straight-line basis. Accumulated

amortization to December 31, 2021 is $80,000 for patents and $45,000 for the franchise.
5. Goodwill was recognized at the time of the purchase as the excess of the cash paid
purchase price over the net identifiable assets.
6. The bonds were issued at face value on December 31, 2005 and are 5%, 20 year, with
interest payable annually each December 31.
7. The 3%, 5-year note payable will be repaid by December 31, 2024 and was signed when
market rates were 3.5%.
Below is the payment schedule:
Payment Amount Interest @ 3.5% Amortization Balance

December 31, 2019 $566,906
December 31, 2020 17,400 19,842 2,442 569,348
December 31, 2021 17,400 19,927 2,527 571,875
December 31, 2022 17,400 20,016 2,616 574,491
December 31, 2023 17,400 20,107 2,707 577,198
December 31, 2024 17,400 20,202 2,802 580,000
8. During the year ended December 31, 2021, no dividends were declared and there was
no preferred or common share activity.
9. On December 31, 2021, the share structure was; common shares, unlimited authorized,
260,000 shares issued and outstanding. $3 preferred shares, non-cumulative, 1,200
authorized, 800 shares issued and outstanding.
10. The company prepares financial statements in accordance with IFRS and investments
in accordance with IFRS 9.
11. The income tax rate is 25%.

Exercises 129
Required:
a. Prepare a classified statement of financial position as at December 31, 2021, in good

form, including all required disclosures identified in Chapter 4. Adjust the account
balances as required based on the additional information presented.
b. Calculate the company’s debt ratio and equity ratio and comment on the results.
c. Assume now that accounts receivable is made up of the following:
Accounts with debit balances $ 580,000

Accounts with credit balances (250,000)
Discuss whether this change in the accounts will affect the liquidity of this company.
Round final ratio answers to the nearest 2 decimal places.
EXERCISE 4–4
Below is the trial balance in no particular order for Hughey Ltd. as at December 31, 2021:
Hughey Ltd.
Trial Balance
Debits Credits
Cash $ 250,000
Accounts receivable 1,015,000
Allowance for doubtful accounts $ 55,000
Prepaid rent 40,000
Inventory 1,300,000
Investments – available for sale (FVOCI) 2,100,000
Land 530,000
Building 770,000
Patents (net) 25,000
Equipment 2,500,000
Accumulated depreciation, equipment 1,200,000
Accumulated depreciation, building 300,000
Bond payable 1,100,000
Common shares 2,500,000
Retained earnings 1,330,000
$8,530,000 $8,530,000

1. The inventory has a net realizable value of $1,350,000. The company uses FIFO method
of inventory valuation.
2. Investments in available for sale securities (FVOCI) have a fair value of $2,250,000.
3. The company purchased patents of $60,000 on January 1, 2015.
4. Bonds are 8%, 25-year and pay interest annually each January 1, and are due December
31, 2030.
5. The 7%, notes payable represent bank loans that are secured by investments in available
for sale securities (FVOCI) with a carrying value of $800,000. Interest is paid each
December 31 and no principal is due until its maturity on April 30, 2022.
6. The capital structure for the common shares are # of authorized, 100,000 shares; issued
and outstanding, 80,000 shares.
Required:
a. Prepare a classified statement of financial position as at December 31, 2021, in good

form, including all required disclosures identified in Chapter 4.
b. Calculate the annual amortization for the patent.
c. Does this company follow IFRS or ASPE? Explain your answer.
EXERCISE 4–5
Below is a list of independent transactions. For each transaction, identify which section of
the statement of cash flows it is to be reported and indicate if it is a cash in-flow (a positive
number) or cash out-flow (negative number). (Hint: recall the use of the accounting equation
A = L + E to help determine if an amount is a positive or negative number.)
Exercises 131
Description Section Amount

Issue of bonds payable of $500 cash
Sale of land and building of $60,000 cash
Retirement of bonds payable of $20,000 cash
Current portion of long-term debt changed from $56,000 to $50,000
Repurchase of company’s own shares of $120,000 cash
Issuance of common shares of $80,000 cash
Payment of cash dividend of $25,000 recorded to retained earnings
Purchase of land of $60,000 cash and a $100,000 note
Cash dividends received from a trading investment of $5,000
Interest income received in cash from an investment of $2,000
Interest and finance charges paid of $15,000
Purchase of equipment for $32,000
Increase in accounts receivable of $75,000
Decrease in a short-term note payable of $10,000
Increase in income taxes payable of $3,000
Purchase of equipment in exchange for a $14,000 long-term note
EXERCISE 4–6
Below is the unclassified balance sheet for Carmel Corp. as at December 31, 2020:
Carmel Corp.
Balance Sheet
Cash $ 84,000 Accounts payable $ 146,000

Accounts receivable (net) 89,040 Mortgage payable 172,200
Investments – trading (FVNI) 134,400 Common shares 400,000
Buildings (net) 340,200 Retained earnings 297,440
Equipment (net) 168,000 $1,015,640
Land 200,000
$1,015,640
The net income for the year ended December 31, 2021, was broken down as follows:
Revenues $1,000,000
Gain 2,200
Total revenue 1,002,200
Expenses
Operating expenses 809,200
Interest expenses 35,000
Depreciation expense – building 28,000
Depreciation expense – equipment 20,000
Loss 5,000
897,200
Net income $ 105,000
The following events occurred during 2021:
1. Investments in traded securities are short-term securities and the entire portfolio was
sold for cash at a gain of $2,200. No new investments were purchased in 2021.
2. A building with a carrying value of $225,000 was sold for cash at a loss of $5,000.
3. The cash proceeds from the sale of the building were used to purchase additional land
for investment purposes.
4. On December 31, 2021, specialized equipment was purchased in exchange for issuing
an additional $50,000 in common shares.
5. An additional $20,000 in common shares were issued and sold for cash.
6. Dividends of $8,000 were declared and paid in cash to the shareholders.
7. The cash payments for the mortgage payable during 2021 included principal of $30,000
and interest of $35,000. For 2022, the cash payments will consist of $32,000 for the
principal portion and $33,000 for the interest.
8. All sales to customers and purchases from suppliers for operating expenses were on
account. During 2021, collections from customers were $980,000 and cash payments to
suppliers were $900,000.
9. Ignore income taxes for purposes of simplicity.
Required:
a. Prepare a classified SFP/BS in good form as at December 31, 2021. Identify which
required disclosures discussed in Chapter 4 were missed due to lack of information?
b. Prepare a statement of cash flows in good form with all required disclosures for the year
ended December 31, 2021. The company prepares this statement using the indirect
method.
Exercises 133
c. Calculate the company’s free cash flow and discuss the company’s cash flow pattern
including details about sources and uses of cash.
d. How can the information from the SFP/BS and statement of cash flows be beneficial to
the company stakeholders (e.g., creditors, investors, management and others)?
EXERCISE 4–7
Below is the comparative balance sheet for Lambrinetta Industries Ltd.:
Lambrinetta Industries Ltd.

Balance Sheet
December 31
2021 2020
Assets:
Cash $ 32,300 $ 40,800
Accounts receivable 79,900 107,100
Investments – trading (FVNI) 88,400 81,600
Land 86,700 49,300
Plant assets 425,000 345,100
Accumulated depreciation – plant assets (147,900) (136,000)
Total assets $ 564,400 $ 487,900
Liabilities and Equity:
Current portion of long-term note 8,000 10,000
Long-term note payable 119,500 75,000
Common shares 130,900 81,600
Total liabilities and equity $ 564,400 $ 487,900
1. Net income for the year ended December 31, 2021 was $161,500.
2. Cash dividends were declared and paid during 2021.
3. Plant assets with an original cost of $51,000 and with accumulated depreciation of
$13,600 were sold for proceeds equal to book value during 2021.
4. The investments are reported at their fair value on the balance sheet date. During 2021,
investments with a cost of $12,000 were purchased. No other investment transactions
occurred during the year. Fair value adjustments are reported directly on the income
statement.
5. In 2021, land was acquired through the issuance of common shares. The balance of the
common shares issued were for cash.
Required: Using the indirect method, prepare the statement of cash flows for the year ended
December 31, 2021 in good form including all required disclosures identified in Chapter 4. The
company follows ASPE.
EXERCISE 4–8
Below is a comparative statement of financial position for Egglestone Vibe Inc. as at December
31, 2021:
Egglestone Vibe Inc.

December 31
2021 2020
Assets:
Cash $ 84,500 $ 37,700
Accounts receivable 113,100 76,700
Inventory 302,900 235,300
Investments – available for sale (FVOCI) 81,900 109,200
Land 84,500 133,900
Plant assets 507,000 560,000
Accumulated depreciation – plant assets (152,100) (111,800)
Goodwill 161,200 224,900
Total assets $1,183,000 $1,265,900
Liabilities and Equity:
Dividend payable 19,500 41,600
Notes payable 416,000 565,500
Common shares 322,500 162,500
Accumulated other comprehensive income 12,500 59,800
Total liabilities and equity $1,183,000 $1,265,900
1. Net income for the 2021 fiscal year was $24,700.
2. During 2021 land was purchased for expansion purposes. Six months later, another
section of land with a carrying value of $111,800 was sold for $150,000 cash.
3. On June 15, 2021, notes payable of $160,000 were retired in exchange for the issuance
of common shares. On December 31, 2021, notes payable for $10,500 were issued for
additional cash flow.
4. Available for sale investments (FVOCI) were purchased during 2021 for $20,000 cash.
By year-end, the fair value of this portfolio dropped to $81,900. No investments from this
portfolio were sold in 2021.
Exercises 135
5. At year-end, plant assets originally costing $53,000 were sold for $27,300, since they
were no longer contributing to profits. At the date of the sale, the accumulated depreci-
ation for the asset sold was $15,600.
6. Cash dividends were declared and a portion of those were paid in 2021. Dividends are
reported under the financing section.
7. Goodwill impairment loss was recorded in 2021 to reflect a decrease in the recoverable
amount of goodwill.
Required:
a. Prepare a statement of cash flows in good form, including all required disclosures iden-
tified in Chapter 4. The company uses the indirect method to prepare the statement.
b. Analyze and comment on the results reported in the statement.

Chapter 5
Revenue
Trouble at Tesco
On November 9, 2014, it was reported that several legal firms were considering launching
a class action suit against British grocery giant Tesco PLC. The claims were related to
revelations made by the company in September that its profits for the first half of the year
were overstated by £263 million. In October, the United Kingdom’s Serious Fraud Office
announced that it was launching its own investigation into the accounting practices at
Tesco. This followed the company’s suspension of eight senior executives along with the
resignation of the CEO.
The issue at Tesco stemmed primarily from a misstatement of a revenue category de-
scribed as “commercial income.” Although the company’s primary business is selling
groceries to consumers, it also earns a significant amount from suppliers. Manufacturers
and suppliers understand that in a grocery store, the location of the product on the shelves
can have a significant effect on the level of sales generated. Many of these suppliers
will offer rebates or other payments to Tesco in exchange for preferential placement of
their products on the shelves. These rebates will often be calculated on a sliding scale,
increasing as the level of sales increases.
In Tesco’s interim financial statements, many of these rebates would need to be estimated,
as the sales level for the entire year would not yet be known. Tesco’s auditor, PwC,
indicated in its 2014 audit report that the determination of commercial income was an area
of audit risk due to the judgment required and possibility of manipulation. Tesco had been
experiencing decreasing market share in 2014, and this may have provided an incentive
for some degree of earnings management. Some analysts suggested that Tesco might
have booked promotional rebates based on historic results rather than current activity.
Problems with revenue recognition have been a source of many accounting errors and
frauds over the years. Given the complex nature of some types of business transactions
and contracts, the criteria for recognition of revenue may not always be clear. When
significant levels of judgment are required to determine the point at which revenue should
be recognized, the opportunity for misstatement grows. Given that many of the com-
plex issues surrounding revenue recognition are not always well understood by financial-
statement readers, managers may sometimes give in to the temptation to “work” the
numbers a little bit.
This chapter will explore some of the issues and judgments required with respect to
revenue recognition and some of the problems that companies like Tesco may face.
137
138 Revenue
(Source: Marriage, 2014)
LO 1: Describe the criteria for recognizing revenue and determine if a company has earned
revenue in a business transaction.
LO 2: Discuss the problem of measurement uncertainty and alternative accounting treat-

ments for these situations.
LO 3: Prepare journal entries for a number of different types of sales transactions.
LO 4: Apply revenue recognition concepts to the determination of profit from long-term con-
struction contracts.
LO 5: Prepare journal entries for long-term construction contracts.
LO 6: Apply revenue recognition concepts to unprofitable long-term construction contracts.
LO 7: Describe presentation and disclosure requirements for revenue-related accounts.
LO 8: Discuss the earnings approach to revenue recognition and compare it to current IFRS
requirements.
Introduction
Revenue is the essence of any business. Without revenue, a business cannot exist. The
basic concept of revenue is well understood by business people, but complex and impor-
tant accounting issues complicate the recognition and reporting of revenue. Sometimes, the
complexity of these issues can lead to erroneous or inappropriate recognition of revenue. In
2007, Nortel Networks Corporation paid a $35 million settlement in response to a Securities
and Exchange Commission (SEC) investigation into its reporting practices. Although several
problems were identified, one of the specific issues that the SEC investigated was Nortel’s
earlier accounting for bill-and-hold transactions. In a separate matter, Nortel was also required
to restate its financial statements due to errors in the timing of revenue recognition for bundled
sales contracts. In this chapter, we will examine these issues and determine the appropriate
accounting treatment for revenues.
1.0 Definition Identify the Contract
Identify the Performance

Obligations
Determine the
Transaction Price
Allocate the
2.0 Revenue Recognition Transaction Price to the
Performance Obligations
Recognize Revenue When

(or as) the Entity Satisfies
a Performance Obligation
Contract Costs
3.0 Applications Bundled Sales

Revenue
Consignment Sales
4.0 Presentation
and Disclosure Sales With
Right of Return
Bill-and-Hold
5.0 The Earnings Arrangements
Approach
Barter Transactions
6.0 IFRS/ASPE Long-term

Key Differences Construction Contracts
5.1 Definition
IFRS 15 defines revenue as “participants income arising in the course of an entity’s ordinary
activities.” Income is defined as “increases in economic benefits during the accounting period
in the form of inflows or enhancements of assets or decreases of liabilities that result in an
140 Revenue
increase in equity, other than those relating to contributions from equity participants.” (CPA
Canada, 2017, IFRS 15 Appendix A).
ASPE defines revenue as “the inflow of cash, receivables or other consideration arising in
the course of the ordinary activities of an enterprise, normally from the sale of goods, the
rendering of services, and the use by others of enterprise resources yielding interest, royalties
and dividends” (CPA Canada, 2017, 3400.03a).
Both definitions refer to the ordinary activities of the entity, which suggests that gains made
from incidental activities, such as the sale of surplus assets, cannot be defined as revenue.
However, these gains are still considered income, as the Conceptual Framework includes
revenue and gains as part of its definition of income. Revenue is realized when goods or
services are converted to cash. The point when cash is realized is usually easy to identify. In a
grocery store, when a customer pays for his or her purchase with cash, the revenue is realized
at that moment. In a wholesale business, when goods are sold on credit, the revenue is not
realized until the account receivable is collected and cash is deposited in the bank. However,
in this case, the revenue would have been recognized at some earlier point when the account
receivable was created. In accounting, the point at which revenue should be recognized is not
always so simple to determine.
5.2 Revenue Recognition
There are two different perspectives on how to recognize revenues:
• The contract-based approach
• The earnings approach
The contract-based approach is the subject of IFRS 15 – Revenue from Contracts with Cus-
tomers. This standard focuses on the contractual rights and obligations of the buyer and
the seller. The earnings approach is currently used in ASPE. This approach focuses on the
process of adding value to the final product or service that is delivered to the customer, and
will be discussed in Section 5.5.
IFRS 15, issued in 2014, is effective for fiscal years beginning on or after January 1, 2018,
although early adoption is allowed. The length of this transition period reflects the anticipated
effect this standard may have on business results and business processes. This standard
was a joint project between IASB and FASB, as both standard-setting bodies were interested
in creating more consistency in the application of revenue-recognition principles. The nature
and complexity of this standard and the resulting process meant that development time was
5.2. Revenue Recognition 141
lengthy. The project was first added to the IASB agenda in 2002, and the first discussion paper
was produced in 2008.
The standard applies to all contractual relationships with customers except for leases, financial
instruments, insurance contracts, and those transactions covered by standards that deal with
subsidiaries, joint arrangements, joint ventures, and associates. The standard also doesn’t ap-
ply to non-monetary exchanges between entities in the same line of business to facilitate sales
to customers or potential customers. The new standard replaces several existing standards,
including IAS 11, IAS 18, IFRIC 13, IFRIC 15, IFRIC 18, and SIC-31.
The standard takes the approach that the essence of the relationship between a business, and
its customers can be characterized as one of contractual rights and obligations. To determine
the correct accounting treatment for these transactions, the standard applies a five-step model:
1. Identify the contract(s) with a customer.
2. Identify the performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations in the contract.
5. Recognize revenue when (or as) the entity satisfies a performance obligation.
The standard provides a significant amount of detail in the application of these steps. We will
focus on some of the key elements of each component of the model.
5.2.1 Identify the Contract
The contract must be approved by both parties and must clearly identify both the goods and
services that will be transferred and the price to be paid for these goods and services. The
contract must be one of commercial substance, and there must be reasonable expectation
that the ultimate amount owing from the customer will be collected. This collectability criterion
will prevent a situation where revenue is recognized and then a provision is immediately made
for an uncollectible account. Under this criterion, the contract cannot be recognized until the
collection is probable. If these conditions are not present, the contract can be continually
reassessed to see if its status changes. The standard also applies guidance on how to deal
with contract modifications. Depending on the circumstances, the modifications may be treated
as either a change to the existing contract or as a completely new contract. A new contract
would exist if the scope of the contract increases due to the addition of distinct goods or
services, and the price of the contract increases by an amount that reflects the entity’s stand-
alone selling prices of the additional goods or services.
142 Revenue
The contract will not exist if each party to the contract has the unilateral, enforceable right
to terminate a wholly unperformed contract without compensating the other party. A con-
tract would be considered wholly unperformed if the entity has not yet transferred any of the
promised goods or services to the customer, and the entity has not received any consideration
or entitlement to consideration. In this situation, there is clearly no revenue to recognize as
there has not been any exchange under the contract.
5.2.2 Identify the Performance Obligations
This is a critical step, as the performance obligations will determine when revenue is recog-
nized. The standard requires that the promised performance obligation be identified either as
distinct goods and services or as a series of distinct goods and services that are substantially
the same and that have the same pattern of transfer to the customer. A performance obligation
exists only if there is a transfer of goods or services to a customer. This limitation in the
definition means that internal administrative tasks required to manage a contract are not, in
themselves, performance obligations.
During the development and implementation of IFRS 15, there was a great deal of discussion
around the concept of distinct goods or services. The definition of “distinct” in this context
contains two criteria: the customer can benefit from the good or service either on its own
or together with other resources that are already available to the customer, and the contract
contains a separately identifiable promise to transfer the good or service. It is important to
note that both of these criteria must be satisfied to meet the definition of “distinct.” For some
contracts, the satisfaction of the second criteria may require some analysis. The standard
provides further clarification by specifying the following indicators of a combined good or
service (i.e., a single performance obligation):
• Significant services in integrating the goods or services with other goods or services are
provided in the contract.
• The goods or services provided significantly modify or customize other goods or services
provided in the contract.
• The goods or services are highly interdependent.
The standard provides further detailed examples to illustrate these concepts. A common,
simple example can also illustrate the idea of “distinct”. Consider a customer who wishes to
build a brick wall. There are two ways this could be done. The customer could arrange with a
local building supply warehouse to deliver all the required materials (bricks, mortar, tools, etc.)
The company could then arrange a separate contract with a local mason to build the wall. In
this case, there are two separate contracts. In the first contract, the performance obligation is
satisfied when the materials are delivered to the building site. The performance obligation in
the second contract will be satisfied when the mason completes construction of the wall.
Now consider a different scenario: the company hires a local contractor to build the wall.
The contractor purchases all the materials and arranges to have them delivered to the building
site. Although these materials could meet the first criteria (i.e., the customer could benefit from
them), the second criteria is not met. The contractor has made a promise for a single good: the
completed wall. The contractor is going to provide significant services in integrating the goods
(assembling the bricks with the mortar), the service modifies the goods, and the goods and
services are interdependent (the skilled labour of the contractor is required to assemble the
raw materials). In this case, the delivery of the materials to the building site does not satisfy a
performance obligation. The performance obligation is not satisfied until the wall is completed.
To provide further clarity on the nature of performance obligations, the standard provides the
following examples of goods and services:
• Sale of goods produced by the entity
• Resale of goods purchased by the entity
• Resale of rights to goods or services purchased by the entity
• Performing a contractually agreed upon task
• Providing a service of standing ready to provide goods or services
• Providing a service of arranging for another party the transfer of goods or services
• Granting rights to goods or services to be provided in the future that the customer can
resell
• Constructing, manufacturing, or developing an asset on behalf of a customer
• Granting licenses
• Granting options to purchase additional goods or services
(CPA Handbook – Accounting, IFRS 15.26)
In some of the examples above, it is apparent that the entity would be acting as an agent for
the benefit of a principal. In determining whether an agency relationship exists, the key factor
to consider is control. If the entity controls the good or service before it is transferred to the
customer, then the entity is a principal. If the entity does not control the good or service, the
entity would be considered an agent. The main concern from an accounting perspective in
these situations is the amount of revenue to recognize. For a principal, the gross amount of
consideration expected from the transaction is considered revenue. For an agent, only the fee
or commission earned from the transfer of goods or services is reported as revenue.
144 Revenue
5.2.3 Determine the Transaction Price
The standard defines the transaction price as the amount of the consideration the entity
expects to be entitled in exchange for transferring promised goods or services, excluding
amounts collected on behalf of third parties. This consideration may be fixed or variable in
nature. As well, there may be an implied financing component present in the consideration.
Also, there are certain contracts that may require the payment of non-cash consideration.
Variable consideration can occur when discounts, rebates, refunds, credits, price concessions,
or other incentives or penalties exist. When variable consideration is present in a contract,
the amount should be estimated using either the expected value (the sum of probability-
weighted amounts from a range of possible amounts) or the most likely amount (usually
more appropriate when the range contains only a few choices). Variable consideration can
be included in the transaction price only if it is highly probable that a significant reversal in
the amount cumulative revenue recognized will not occur in the future. The standard does not
define what is meant by “highly probable”, but it does provide a list of factors to consider when
making this assessment. These situations require professional judgment and analysis of both
quantitative and qualitative factors.
In some contracts, the entity may be providing significant financing services, even if these
are not explicitly stated in the contract. A simple example would be goods sold which require
payment in two years’ time. Although the contract may not state an interest rate, there is clearly
a financing component present. The selling entity needs to account for the time value of money
in determining the portion of the sale that relates to the goods and the portion that relates to the
financing provided. In determining if a significant financing component exists, the entity should
consider the difference between the consideration and the cash selling price of the goods or
services, the length of time between the transfer of control and the customer’s payment, and
prevailing interest rates in the relevant market. The discount rate used should reflect the rate
that would be arrived at if the entity and the customer had engaged in a separate financing
contract. This rate should reflect current market conditions, as well as the customer’s credit
rating, collateral offered, and any other relevant factors. As a practical expedient, the standard
allows entities to ignore the financing component if the time from delivery of goods or services
to receipt of payment is expected to be one year or less.
When a contract allows non-cash consideration to be paid by a customer, that consideration

should be measured at its fair value. In some cases, it may not be possible to determine the
fair value of the consideration received. In these cases, the entity should use the stand-alone
selling prices of the promised goods or services to determine the transaction price.
5.2.4 Allocate the Transaction Price to the Performance Obligations
Where multiple performance obligations are included in a single-price contract, the price should
be allocated based on the relative proportions of the stand-alone selling prices of each com-
ponent at the contract inception date. Where the stand-alone selling prices cannot be deter-
mined, other suitable estimation methods include
• the adjusted market assessment approach,
• the expected cost plus a margin approach, and
• the residual approach (permissible only in limited circumstances).
The application of these approaches may result in the identification of performance obligations
that hadn’t previously been identified due to the lack of stand-alone prices. If the customer
receives a discount from purchasing a bundle of goods or services, this discount would nor-
mally be allocated in a proportional manner to the different performance obligations. The
standard does, however, allow for discounts to be allocated in a disproportional manner if
certain criteria are met. When variable consideration is present in a contract, the standard
allows the variable component to be allocated to specific performance obligations if certain
criteria are met. Otherwise, the variable consideration would be allocated in a proportional
manner, similar to other consideration.
5.2.5 Recognize Revenue When (or as) the Entity Satisfies a Performance
Obligation
Revenue should be recognized when the performance obligation has been satisfied. This
occurs when the entity has transferred control of an asset to the customer. In this context,
an asset includes either goods or services. A service is considered an asset because the
customer obtains a benefit from its use, even if only briefly. The performance obligations can
be satisfied either at a point in time or over time.
The standard defines control as the ability to direct the use of, and obtain substantially all of
the benefits from the asset. (CPA Canada Handbook – Accounting, IFRS 15.33). Benefits
are described as future cash flows, and can take the form of either inflows or reductions of
outflows. Thus, cash flows can include not only the revenue derived directly from selling the
asset, but also savings from using the asset to enhance other assets, or even the settlement
of liabilities with the asset.
Many common business transactions result in performance obligations being satisfied at a

point in time. This point could also be described as the critical event. For example, when you
146 Revenue
buy groceries at your local convenience store, the critical event occurs when you exchange
cash for possession of the goods. Once you leave the store with the groceries, revenue has
been earned by the store. The proprietor no longer has any responsibility for or control over
the goods. Other factors that can be considered when determining if control of an asset has
been transferred include the transfer of legal title, the transfer of physical possession, the
acceptance by the customer of the asset, the entity’s entitlement to payment by the customer,
and the transfer of significant risks and rewards of ownership. In the example of groceries
purchased, the reward is the realization of the cash received from the sale. Prior to the sale,
the risk to the vendor is that the food products may pass their sell-by date or may not be
saleable due to changes in consumer tastes. Once you have purchased the goods, you are
accepting responsibility for consuming the product prior to the sell-by date. Thus, the rewards
have been transferred to the seller and the risks have been transferred to the buyer.
Often, the question of control can be answered by looking at a number of the factors identified
above. As long as a company possesses the goods and still holds the title to the goods, there
is both a risk (i.e., goods could be damaged, stolen, or destroyed) and a reward (i.e., goods
can pledged or sold) available to the vendor. Sometimes, a vendor may transfer legal title to
the customer but still maintain physical possession of the goods. In late 2000, Nortel Networks
Corporation recorded approximately $1 billion of revenue using bill-and-hold transactions.
These transactions were recorded as sales, but the company maintained possession of the
goods until some later date when the customer requested delivery. In order to promote these
types of sales, the company offered several different incentives to its customers. To report
these types of transactions, US GAAP required that several conditions be met, including the
conditions that the transaction must be requested by the customer and serve some legitimate
business purpose. Nortel’s actions violated these two conditions, and as such, the company
was later required to restate revenues for the fourth quarter by over $1 billion.
The selling of services can create further accounting problems, as there is no longer the
obvious transfer of a physical product to indicate completion of the earnings process. When
you get a haircut, the service will be completed when you are satisfied with the cut and the
barber enters the sale into the cash register. This can still be described as revenue earned at
a point in time, as the completion of the haircut can be seen to be a critical event. However,
some activities can take longer to complete, and they can even extend over several accounting
periods. When a company agrees to provide a service over a period of time that crosses
several fiscal years, the problem is to determine in which accounting periods to recognize the
revenue. IFRS 15 requires one of three criteria be met to recognize revenue over time:
• The customer simultaneously receives and consumes benefits as the entity performs;
• The entity’s performance creates or enhances an asset that the customer controls; or
• The entity’s performance does not create an asset with an alternative use to the entity
and entity has an enforceable right to payment
(CPA Canada Handbook – Accounting, IFRS 15.35)

When recognizing revenue for a performance obligation that is satisfied over time, it is essential
that the entity have a reliable method for measuring progress. These methods should be
based on either inputs or outputs. If the entity cannot reasonably measure its progress
towards satisfaction of the performance obligation, then revenue should not be recognized.
In some cases, although reliable measures of progress are not available, there is still a
reasonable expectation that costs incurred will be recovered. In this instance, revenue would
be recognized equal to the costs incurred. This is referred to as the zero-margin method.
Revenue recognition for long term contracts will be discussed further in Section 5.3.6.
Accounting for revenue over time can create further problems when both goods and services
are delivered. For example, in 2006, Nortel Networks was required to restate its financial
statements due to improper accounting of several “multiple element arrangements.” Nortel
was engaged in many different types of long-term contracts with customers where installation,
network planning, engineering, hardware, software, upgrades, and customer-support features
were all included in the contract price. The accounting for these contracts was complicated,
and the restatement was required because certain undelivered products and services were
not considered separate accounting units, as no fair value could be determined for them.
5.2.6 Contract Costs
IFRS 15 also provides guidance on how to account for costs incurred to obtain and fulfill a
contract. When obtaining a contract, any incremental costs incurred should be capitalized as
an asset and amortized over the life of the contract. These costs only include those direct costs
that would not have been incurred if the contract had not been obtained. A common example
would be commissions paid to sales staff. As a practical expedient, the standard allows the
costs to be expensed immediately for contracts terms of one year or less. This particular
section of the standard has generated some debate, particularly in the telecommunications
sector. Common practice in this industry usually involves expensing employee commissions
at the time the contract is signed. Some industry representatives have expressed concern
that the requirement to capitalize contract costs, along with other aspects of the standard, will
result in significant changes and investments in IT systems to properly track the information.
For costs incurred to fulfill a contract, the standard requires capitalization only if the costs relate
directly to the contract, the costs generate or enhance resources that will be used to satisfy the
performance obligations, and the costs are expected to be recovered. These conditions will
generally prevent the capitalization of general and administrative costs that are not explicitly
chargeable under a contract or the cost of wasted resources that are not reflected in the price of
the contract. However, overhead costs such as project management, supervision, insurance,
and depreciation may be eligible for capitalization if they relate directly to the contract.
148 Revenue
5.3 Applications
IFRS 15 provides fourteen sections of application guidance which elaborate on certain aspects
of the standard as they relate to specific situations. As well, the standard provides sixty-three
illustrative examples for further clarity. In this section, we will examine some of the examples
and guidance.
5.3.1 Bundled Sales
Telurama Inc. sells mobile telephones with two-year bundled airtime and data plans. The
stand-alone selling price of the telephone is $600. The the airtime and data plan does not
have an observable stand-alone selling price, but Telurama has used the adjusted market
assessment approach to estimate the stand-alone selling price as $1,000. As the mobile
telephone business is very competitive, Telurama is required to sell the bundled package for
$1,400. Telurama has determined that the discount should be allocated proportionally to the
two performance obligations. In this case, the revenue would be recognized as follows:
Component Calculation Allocation

Telephone [600 ÷ (600 + 1,000)] × 1,400 $ 525
Airtime and data [1,000 ÷ (600 + 1,000)] × 1,400 $ 875
Total $ 1,400
If the airtime and data plan was sold to different customer groups for a broad range of different
prices, Telurama could use the residual approach instead, as the stand-alone selling price for
this performance obligation would not be observable. With this approach, the value of the
observable stand-alone selling price (the telephone) is subtracted from the total contract value
to arrive at the value of the unobservable stand-alone selling price (the airtime and data plan).
In this example, Telurama would recognize revenue as follows:
Component Calculation Allocation

Telephone stand-alone price $ 600
Airtime and data 1,400 − 600 $ 800
Total $ 1,400
In either case, revenue will be recorded based on the allocation calculated above. The rev-
enue for the telephone will be recorded immediately upon delivery to the customer, and the
remaining amount relating to the airtime and data will be reported as unearned revenue that
will be recognized over the term of the contract. The journal entry at the time of sale to record
this transaction using the first example would look like this:
5.3. Applications 149
General Journal
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400
Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
Unearned revenue . . . . . . . . . . . . . . . . . . . . . . . . . 875
5.3.2 Consignment Sales
Sometimes a retailer may not want to take the risk of purchasing a product for resale. The
retailer may not want to tie up working capital or may think the product is too speculative or
risky. In these cases, a consignment arrangement may be appropriate. Under this type of
arrangement, the manufacturer of the product (the consignor) will ship the goods to the retailer
(the consignee), but the manufacturer will retain legal title to the product. The consignee
agrees to take care of the product and make efforts to the sell the product, but no guarantee of
performance is made. As well, the agreement will likely require the return of the goods to the
consignor after a specified period, if the goods are not sold. Thus, the performance obligation
has not been satisfied when the goods are transferred to the consignee, and the consignor
cannot recognize revenue at this point. The goods will, thus, remain on the consignor’s books
as inventory until the consignee sells them. When the consignee actually sells the product,
an obligation is now created to reimburse the consignor the amount of the sales proceeds,
less any commissions and expenses that are agreed to in the contract for the consignment
arrangement. At the time of sale, the consignor can recognize the revenue from the product,
and the consignee can recognize the commission revenue.
Assume the following facts: Dali Printmaking Inc. produces fine-art posters. Dali ships 3,000
posters to Magritte Merchandising Ltd. on a consignment basis. The total cost of the posters is
$12,000, and Dali pays $550 in shipping costs. Magritte pays $1,200 for advertising costs that
will be reimbursed by Dali. During the year, Magritte sells one-half of the posters for $23,000.
Magritte informs Dali of this and pays the amount owing. Magritte’s commission is 15 percent
of the sales price. The accounting for this type of transaction looks like this:
Dali Printmaking Inc. (consignor)

150 Revenue
General Journal
Inventory on consignment . . . . . . . . . . . . . . . . . . . . . 12,000
Finished goods inventory. . . . . . . . . . . . . . . . . . . 12,000
To segregate consignment goods.
Inventory on consignment . . . . . . . . . . . . . . . . . . . . . 550
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 550
To record freight.
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,350
Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200
Commission expense (15% × $23,000) . . . . . . . . 3,450
Consignment revenue . . . . . . . . . . . . . . . . . . . . . . 23,000
To record receipt of net sales.
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,275
Inventory on consignment . . . . . . . . . . . . . . . . . . 6,275
To record COGS: [(12,000 + 550) × 50%].
Magritte Merchandising Ltd. (consignee)
General Journal
Account receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200
To record payment of advertising.
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,000
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . 23,000
To record sales of consigned goods.
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,000
Accounts receivable. . . . . . . . . . . . . . . . . . . . . . . . 1,200
Revenue from consignment sales . . . . . . . . . . 3,450
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,350
To record payment to consignor: 15% ×
$23,000 = $3,450.
5.3.3 Sales With Right of Return
It is a common practice in the retail sector to allow customers to return products for various
reasons, within a certain period of time. When the product is returned, the customer may
receive a full refund, a credit to be applied against future purchases, or a replacement prod-
uct. The accounting issue for the company is whether the full amount of revenue should
be recognized at the time of sale, given that a certain number of returns may be expected.
The general approach used here is to record revenue only in the amount of consideration
expected to be received. In other words, the company needs to make an estimate at the time
of sale of the amount of returns expected, and then exclude this amount from reported revenue.
This amount should be reported as a refund liability. As well, the company should report an
asset equal to the expected amount of product to be returned. The asset would be adjusted
against the cost of goods sold in the period of sale. At the end of every accounting period,
the estimates used to arrive at the refund liability and asset should be reviewed and adjusted
where necessary. It is expected that most companies should be able to make reasonable
estimates of these amounts, using historical, industry, technical, or other data.
Consider the following example. Wyeth Mart sells high quality paintbrushes for use in fine
art applications. Each brush costs the company $15 and sells for $25. Wyeth Mart offers
a full refund for any unused product that is returned within 30 days of purchase, and the
company expects that these returned products can resold for a profit. The company has
reviewed historical sales data and estimated that 2% of products sold will be returned for a
refund. During the month of May, 1,000 paintbrushes are sold for cash. The journal entries in
May would be:
General Journal
Cash (1,000 × $25) . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000
Sales revenue (1,000 × $25 × 98%) . . . . . . . 24,500
Refund liability (1,000 × $25 × 2%) . . . . . . . . 500
Cost of goods sold (1,000 × $15 × 98%) . . . . . . 14,700

Refund asset (1,000 × $15 × 2%) . . . . . . . . . . . . . 300
Inventory (1,000 × $15) . . . . . . . . . . . . . . . . . . . . 15,000
In June, if 20 brushes are returned, the journal entry will be:
General Journal
Refund liability (20 × $25) . . . . . . . . . . . . . . . . . . . . . 500
Inventory (20 × $15) . . . . . . . . . . . . . . . . . . . . . . . . . . 300
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
Refund asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300
If the amount returned differs from estimated amount, the refund liability and refund asset will
need to be adjusted once the return period expires. This is an ongoing process, as most
companies will continue to make new sales during the period. As a practical matter, many
companies will only review the balances of the refund liability and refund asset account at the
annual reporting date.
5.3.4 Bill-and-Hold Arrangements
There are times when a customer may purchase goods from a company, but not take physical
possession of the goods until a later date. Customers may have legitimate reasons for doing
this, including a lack of warehouse space, delays in their own productions processes, or the
need to secure a supply of a scarce product. When the selling entity is considering whether
152 Revenue
to recognize revenue on these types of contracts, it needs to consider if control of the goods
has been transferred to the customer. Aside from the normal criteria that are used to evaluate
control, an additional three conditions must be satisfied in bill-and-hold transactions:
• The reason for the bill-and-hold transaction must be substantive;
• The product must be identified separately;
• The entity must not have the ability to use or resell the product to another customer.
(CPA Canada Handbook – Accounting, IFRS 15.B81)
Consider the following example. Koenig Ltd. processes rare-earth elements used in certain
technological applications. One of these elements forms a critical component of a customer’s
product. The customer has requested Koenig Ltd. set aside a one-year supply of the element
to ensure that its production process is not interrupted. The customer’s factory is in close prox-
imity to Koenig’s warehouse, and transportation between the two locations is easily facilitated.
The customer agrees to pay for the entire one-year supply, as well as a monthly rental fee to
cover Koenig’s cost of storing the product in its warehouse. The entire payment of $500,000,
representing the cost of the element and 12 months of rent, is received on December 29,
2022. Koenig has separately identified and segregated the product in its warehouse, and the
contract with the customer specifies that product cannot be sold to another customer. The fair
value of the warehouse rental service being provided is $800 per month.
In this case, the revenue from the sale of the product can be recognized on December 29, 2022
because the reason for the bill-and-hold transaction is substantive (the customer requested it),
the product has been identified separately, and the contract specifies that the product cannot
be resold. Assuming the transaction price has been determined using the fair value of the
product and rental service, revenue will be recognized as follows:
Revenue related to rental service ($800 × 12)=$9,600

Revenue related to product ($500,000 − $9,600)=$490,400
Thus, on December 29, 2022, Koenig will recognize revenue of $490,400 and report unearned
revenue of $9,600. The $9,600 will be recognized as revenue at the rate of $800 per month
over the next year. If the holding period were longer than one year, Koenig would also need to
consider the presence of a financing component in the transaction price.
5.3.5 Barter Transactions
When a customer and an entity agree that payment for goods or services can be made using
non-cash consideration, the non-cash consideration received should be reported at its fair
value. Assume that an oil-and-gas company wishes to trade a quantity of crude oil for natural
gas that is used to power the refinery where the oil is processed. The natural gas will be
consumed and will not be held in inventory. As these two products have different uses for the
company, this transaction has commercial substance. Assume that the fair value of the natural
gas received is $10,000, and the cost of the crude oil traded is $7,000. The journal entry for
this transaction would be as follows:
General Journal
Utility expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Crude oil inventory . . . . . . . . . . . . . . . . . . . . . . . . . 7,000
5.3.6 Long-Term Construction Contracts
Many large construction projects can take several years to complete. With these types of
projects, a significant amount of professional judgment is required to determine when to
recognize revenue. An obvious approach may be to simply wait until the completion of the
project before recognizing revenue. However, this approach would not properly reflect the
periodic activities of the business. Although contracts of this nature are usually complex, they
do usually establish the right of the contractor to bill for work that is completed throughout
the project and result in a transfer of control to the customer. Because the contractor is
adding economic value to the product, while at the same time establishing a legal right to
collect money for work performed, it is appropriate to recognize revenue on a periodic basis
throughout the life of the project. This method of recognizing revenue and related costs is
referred to as the percentage-of-completion method.
The most difficult part of applying this method is determining the proportion of revenue to
recognize at the end of each accounting period. Both inputs (labour, materials, etc.) and
outputs (square footage of a building completed, sections of a bridge, etc.) can be used,
but judgment must be applied to determine which approach results in the most accurate
measurement of progress on the project. One of the problems with output methods is that the
measure may not accurately represent the entity’s progress toward satisfying the performance
obligation. With input methods, the problem may be that the input measured does not directly
correlate to the transfer of control of goods or services to the customer. A common approach
that is used by many construction companies is called the cost-to-cost basis. This approach
uses the dollar value of inputs as the measurement of progress. More precisely, the proportion
of costs incurred to date to the current estimate of total project costs is multiplied by the total
expected revenue on the project to determine the amount of revenue to recognize. When this
method is used, it is assumed that costs incurred do correlate to the transfer of control of
goods and services to the customer and that these costs are a reasonable representation of
the entity’s progress toward satisfying the performance obligation. This approach is illustrated
in more detail in the examples below.
154 Revenue
Example 1: Profitable Contract
Salty Dog Marine Services Ltd. commenced a $25 million contract on January 1, 2020, to
construct an ocean-going freighter. The company expects the project will take three years to
complete. The total estimated costs for the project are $20 million. Assume the following data
for the completion of this project:
2020 2021 2022

Costs to date 5,000,000 12,000,000 20,100,000
Estimated costs to complete project 15,000,000 8,050,000
Progress billings during the year 4,500,000 7,000,000 13,500,000
Cash collected during the year 4,200,000 6,800,000 14,000,000
The amount of revenue and gross profit recognized on this contract would be calculated as
follows:
2020 2021 2022

Costs to date (A) 5,000,000 12,000,000 20,100,000
Estimated costs to complete project 15,000,000 8,050,000 0
Total estimated project costs (B) 20,000,000 20,050,000 20,100,000
Percent complete (C = A ÷ B) 25.00% 59.85% 100.00%
Total contract price (D) 25,000,000 25,000,000 25,000,000
Revenue to date (C × D) 6,250,000 14,962,500 25,000,000
Less previously recognized revenue (6,250,000) (14,962,500)
Revenue to recognize in the year 6,250,000 8,712,500 10,037,500
Costs incurred the year 5,000,000 7,000,000 8,100,000
Gross profit for the year 1,250,000 1,712,500 1,937,500
Note that the costs incurred in the year are simply the difference between the current year’s
costs to date and the previous year’s costs to date. The total amount of gross profit recog-
nized over the three-year contract is $4,900,000, which represents the difference between the
contract revenue of $25 million and the total project costs of $20.1 million. It is not uncommon
for the total project costs to differ from the original estimate. Adjustments to estimated project
costs are always captured in the current year only. It is assumed that estimates are based on
the best information at the time they are made, so it would be inappropriate to adjust previously
recognized profit.
The journal entries to record these transactions in 2020 would look like this:
General Journal
Construction in progress. . . . . . . . . . . . . . . . . . . . . . . 5,000,000
Materials, payables, cash, etc. . . . . . . . . . . . . . 5,000,000
To record construction costs.
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,500,000
Billings on construction . . . . . . . . . . . . . . . . . . . . 4,500,000
To record billings.
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,200,000
Accounts receivable. . . . . . . . . . . . . . . . . . . . . . . . 4,200,000
To record collections.
Construction expenses . . . . . . . . . . . . . . . . . . . . . . . . 5,000,000
Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,250,000
To recognize revenue.
Construction in progress is a balance sheet account that represents accumulated costs to

date on a project plus any recognized profit. Billings on construction is also a balance
sheet account; it represents total amounts billed to the customer. These two accounts are
normally presented on a net basis on the balance sheet, and may sometimes be described
as Contract Asset/Liability. If construction in progress exceeds billings on construction, the net
balance would be reported as recognized revenues in excess of billings. This asset would be
reported as either current or noncurrent, depending on the length of the contract. If billings on
construction exceeds construction in progress, the net balance would be reported as billings
in excess of recognized revenues. This liability would also be either current or noncurrent.
On the income statement, the company would report the revenues and construction expenses,
with the difference being reported as gross profit.
In 2022, once the contract is completed, an additional journal entry is required to close the
billings on construction and construction in progress accounts:
General Journal
Billings on construction . . . . . . . . . . . . . . . . . . . . . . . . 25,000,000
Construction in progress . . . . . . . . . . . . . . . . . . . 25,000,000
To record completion.
156 Revenue
Example 2: Unprofitable Contract
Although it would be ideal if contract costs could always be accurately estimated, most often
this is not the case. Unexpected difficulties can occur during the construction process, or costs
can rise due to uncontrollable economic factors. Whatever the reason, it is quite likely that the
actual total costs on the project will differ from the original estimates. If costs rise during an
accounting period, this situation is treated as a change in estimate, as it is presumed that
the original estimates were based on the best information available at the time. A change
in estimate is always applied on a prospective basis, which means the current period is
adjusted for the net effect of the change, and future periods will be accounted for using the new
information. There is no need to restate the prior periods when there is a change in estimate.
If the revised estimate of costs will still result in the contract earning an overall profit, the only
effect of increased cost estimates will be to reverse any previously overaccrued profits into the
current year. This may result in a loss for the current year, but the project will still report a total
profit over its lifespan.
Sometimes, however, cost estimates may increase so much that the total project becomes
unprofitable. That is, the total revised project costs may exceed the total revenue on the
project. This situation is referred to as an onerous contract, which results in a liability. When the
unavoidable costs of fulfilling a contract exceed the economic benefits to be derived from the
contract, a conservative approach should be applied, and the total amount of the expected loss
should be recorded in the current year. In determining the unavoidable costs on the contract,
the entity should consider the least costly option available, even if this means cancelling the
contract and paying a penalty. This treatment is required because it is important to alert
financial-statement readers of the potential total loss, regardless of the stage of completion,
so that they are not misled about the realizable value of assets or income. Onerous contracts
will be discussed in a later chapter.
To illustrate this situation, consider our Salty Dog example again, with one change. Assume
that in 2021, due to a worldwide iron shortage, the expected costs to complete the project rise
from $8,050,000 to $18,000,000. However, in 2022, it turns out that the drastic rise in iron
prices was only temporary, and the final tally of costs at the end of the project is $26,500,000.
The profit on the project would be calculated as follows:
2020 2021 2022

Costs to date (A) 5,000,000 12,000,000 26,500,000
Estimated costs to complete project 15,000,000 18,000,000 0
Less previously recognized revenue 0 (6,250,000) (10,000,000)
Revenue to recognize for the year 6,250,000 3,750,000 15,000,000
Costs incurred for the year 5,000,000 7,000,000 14,500,000
Gross profit (loss) for the year 1,250,000 (3,250,000) 500,000
Additional loss to recognize1 (3,000,000) 3,000,000
Gross profit (loss) for the year (6,250,000) 3,500,000
Notice that the total loss recognized over the life of the project is $1,500,000, which reconciles
with the total project revenue of $25,000,000 minus total project costs of $26,500,000.
Other Considerations
There may be cases where input costs include the purchase of a single, significant asset. The
entity may be required to install the asset as part of the contract, but may not have anything
to do with the construction of the asset itself. In this case, the use input costs may be a
misleading way to measure progress toward satisfaction of the performance obligation, as the
entity does not contribute to the construction of the asset.
Consider the following example. Rohe Construction Ltd. signs a contract with a customer to
install a distillation tower in an oil refinery. Rohe Construction Ltd. purchases the distillation
tower from a supplier for $3,000,000 and delivers it to the work site on November 20, 2022. At
this time, the customer obtains control of the tower. The company estimates that it will take six
months to install the distillation tower, and that the total project costs, excluding the tower, will
be $1,200,000. The total value of the contract is $5,000,000.
The company has determined that using total input costs would be a misleading way to
represent its progress toward satisfying the performance obligation. Instead, it will recognize
revenue from the distillation tower itself using the zero-margin method, and revenue from the
installation services using the percentage-of-completion method. Assume that by December
1
Note: The additional loss to recognize in 2021 represents the loss expected at this point on work not yet
completed (i.e., 60% × [25,000,000 − 30,000,000]). This additional loss gets reversed in 2022, because there
is no further work to complete once the project is finished. By recognizing this additional amount in 2021, the
financial statements will show the total expected loss on the project at this point. In 2021, the additional loss will
be journalized by adding it to the total of the construction expenses account recognized.
158 Revenue
31, 2022, the company has incurred $300,000 of costs, excluding the purchase of the tower.
Revenue would be recognized as follows:
Tower Installation Total

Revenue 3,000,000 500,000 3,500,000
Cost of goods sold 3,000,000 300,000 3,300,000
Gross profit 0 200,000 200,000
NOTE: Installation revenue is calculated as ($5,000,000−$3,000,000)×($300,000÷$1,200,000)
Using this approach, the total profit recorded to date of $200,000 represents 25% of the total
expected project profit of $800,000 ($5,000,000 − $3,000,000 − $1,200,000). This makes
sense, as the company has incurred 25% of the total expected costs, excluding the tower
itself. The company doesn’t recognize profit from the tower itself, as the tower’s delivery does
not represent satisfaction of the company’s performance obligation to install the tower.
The zero-margin method can also be applied in situations where it is difficult to measure the
outcome of a performance obligation. This could occur, for example, in the early stages of
a long-term construction contract where significant progress cannot yet be measured. If the
entity believes that costs incurred will ultimately be recoverable under the contract, then the
zero-margin method can be applied, and the company will recognize revenue equal to the
costs incurred. Once the entity determines that progress is now reliably measurable, it can
then start applying the percentage-of-completion method.
5.4 Presentation and Disclosure
IFRS 15 requires the presentation of contract assets or liabilities on the balance sheet once
performance of the contract occurs. Contract assets or liabilities should be reported separately
from receivables under the contract. Receivables are defined as unconditional rights to consid-
eration. The standard allows for alternate terminology in describing the contract asset/liability,
as long is it is clearly distinguishable from the receivable.
The standard has fairly extensive quantitative and qualitative disclosure requirements for con-
tracts with customers. These requirements were designed to address a deficiency in previous
standards regarding the level of detail disclosed for revenue transactions. The disclosures
provide information about the contracts themselves, the judgments applied in accounting for
the contracts, and any assets recognized by creating or fulfilling the contract. Some of the key
disclosures include:
• Revenue and impairment losses from contracts with customers

5.5. The Earnings Approach 159
• Sufficient disaggregation of revenue categories to depict how the nature, amount, timing,
and uncertainty of revenue amounts are affected by economic factors
• A reconciliation of opening and closing contract asset/liability balances, including an ex-

planation of how satisfaction of performance obligations relates to the timing of customer
payments
• A detailed description of performance obligations
• Details of transaction prices allocated to unsatisfied performance obligations
• Details of judgments applied in determining the performance obligations and the alloca-
tion of transaction prices to those obligations
• Explanations of methods used to determine the timing of satisfaction of performance

obligations over time
• Details of methods, inputs, and assumptions used to determine and allocate transaction
prices
• Details of assets recognized from costs to obtain or fulfill a contract
• The application of any practical expedient allowed under the standard
5.5 The Earnings Approach
ASPE uses a different approach to revenue recognition. This approach, often referred to as the
earnings approach, focuses on how an entity adds value during the completion of a business
transaction. While IFRS focuses on the balance sheet (contract assets and liabilities), ASPE
focuses more on the processes the entity undertakes to earn revenue. In this sense, it can be
thought of as income statement approach to revenue.
With the earnings approach, revenue is recognized when four conditions are met:
• The seller has transferred the significant risks and rewards of ownership to the buyer
• The seller maintains no continuing managerial involvement or control over the goods
• Reasonable assurance exists regarding the measurement of consideration to be re-

ceived and the extent to which goods can be returned
• Collection of the consideration is reasonably assured

160 Revenue
(CPA Canada Handbook – Accounting, ASPE 3400.04 and .05)
Although conceptually this approach appears quite different from the IFRS five-step approach,
the results will often be the same when applying the two methods to the same circumstances.
The transfer of risks and rewards of ownership under ASPE will often coincide with the sat-
isfaction of a performance obligation under IFRS. There are, however, some situations where
the results will be different under the two approaches.
One area where IFRS and ASPE differ is in the treatment of long term contracts. ASPE allows
for either the percentage-of-completion method or the completed contract method to be used.
The choice between methods is based on the accountant’s professional judgment as to which
method better relates the revenue to the work accomplished. The completed contract method
would usually be used when a company is unable to make reasonable estimates of progress or
performance of the contract consists of a single act. Under the completed contract method, no
revenues or expenses are recognized until the contract is completed. This means the income
statement will not reveal any information about the company’s progress on the contract, as
all costs and billings will simply be accumulated in balance sheet accounts. In the year the
contract is completed, all revenue and expenses are recognized. Although this method avoids
the problem of estimation error, it does not provide useful information in the interim periods
before project completion.
5.6. IFRS/ASPE Key Differences 161
IFRS ASPE
Revenue is recognized by applying the five- Revenue is recognized using the earnings
step process. The focus is on performance approach. The focus is on the transfer of
obligations and contract assets and liabili- risks and rewards of ownership.
ties.
The percentage-of-completion method Either the percentage-of-completion method
should be used for long-term contracts, or the completed-contract method can be
unless progress is not measurable, in which used, depending on which more accurately
case the zero-margin method should be relates the revenues to the work accom-
used. plished. The completed contract method
should only be used if progress toward com-
pletion of the contract cannot be measured
or if performance consists of a single act.
Barter transactions are measured at fair Barter transactions are measured at fair
value. value when the transaction has commercial
substance. If there is no commercial sub-
stance, the asset acquired is measured at
the carrying value of the asset given up,
adjusted for any cash consideration.
Specific guidance provided on determination Payments received over time are discounted
of the appropriate discount rate for payments at the prevailing market rate.
received over time.
Disclosure requirements are more specific Disclosure requirements are less detailed
and detailed. and indicate only that accounting policies
and major categories should be disclosed.
Chapter Summary
LO 1: Describe the criteria for recognizing revenue and determine if a company

has earned revenue in a business transaction.
Under IFRS, revenue is recognized using a five-step process: 1) identify the contract, 2) iden-
tify the performance obligations, 3) determine the transaction price, 4) allocate the transaction
price to the performance obligations, and 5) recognize revenue when a performance obligation
is satisfied. Performance obligations must relate to distinct goods or services. Performance
obligations can be satisfied over time or at a point in time. The amount of revenue to be
162 Revenue
recognized from a performance obligation will depend on whether the entity is acting as a
principal or an agent. Incremental costs incurred to obtain or fulfill a contract should be
capitalized and amortized over the life of the contract. For long-term contracts, a rational
method of recognizing revenue will need to be applied, based on some method of measuring
progress.
LO 2: Discuss the problem of measurement uncertainty and alternative

accounting treatments for these situations.
Measurement uncertainty can occur when the contract includes variable consideration, an
implied financing component, non-cash consideration, or a discount on a bundle of goods and
services. The accounting treatment will depend on the nature of the measurement problem.
Where sales are bundled, the consideration will normally be allocated based on the relative
stand-alone selling prices of each component. Variable consideration should be measured at
the expected value or most likely amount. Interest, even if not explicitly stated in the contract,
should be identified as a separate performance obligation, unless the contract period is less
than one year. Non-cash consideration should be reported at its fair value.
LO 3: Prepare journal entries for a number of different types of sales transactions.
For bundled sales, consideration should be allocated proportionally, based on the stand-alone
selling price of each component. The residual value approach would only be appropriate if
the stand-alone selling price of a component was not determinable. For consignment sales,
inventory first needs to be reclassified. Revenue from consignment sales should not be
recorded until the consignee actually sells the goods to a third party. Costs of the transaction
also need to be recorded. For sales with a right of return, an accrual of the estimated amount of
the refund liability needs to be recorded, along with an estimate of the amount of refund assets
expected to be received from customers. For bill-and-hold arrangements, revenue should only
be recognized if control has been transferred to the customer. Additional criteria will need to
be evaluated in making this determination. For non-monetary exchanges, revenue should be
recorded based on the fair value of the goods or services received.
LO 4: Apply revenue recognition concepts to the determination of profit from

long-term construction contracts.
For a long-term construction contract, profits should be recognized in some rational manner
over the life of the project. To do this, reliable estimates of progress are required. Input or
output measures may be used. Many construction companies prefer to use the cost-to-cost
Chapter Summary 163
method, which measures progress in terms of the dollar value of inputs. If progress cannot be
reliably measured, then profits should be reported using the zero-margin method.
LO 5: Prepare journal entries for long-term construction contracts.
Costs are accumulated a construction-in-progress account. When profit is estimated at the

end of the year using the percentage-of-completion method, the revenue and related expense
will be recorded, with the net profit being added to the construction-in-progress account. Also,
journal entries will record billings to customers and collections of those billings. At the end of
the construction contract, the construction-in-progress account will be zeroed out against the
billings account. The terms “contract asset” and “contract liability” may also be used in place
of the construction-in-progress and billings accounts.
LO 6: Apply revenue recognition concepts to unprofitable long-term construction

contracts.
When a construction contract is predicted to be unprofitable, resulting in an onerous contract,

the entire projected loss on the contract needs to be recognized immediately. Once the project
is completed, this amount will be adjusted so that the actual amount of the project loss is
reported. This approach results in inconsistent amounts of profit being reported in each year
of the project, but the total profit will be correct over the life of the project.
LO 7: Describe presentation and disclosure requirements for revenue-related

accounts.
Contract assets and liabilities should be presented separately from contract receivables on
the balance sheet. IFRS 15 contains detailed qualitative and quantitative disclosure require-
ments, including disaggregation of revenue categories, descriptions and reconciliations of
performance obligations, and discussions of methods and judgements applied in determining
revenue.
LO 8: Discuss the earnings approach to revenue recognition, and compare it to

current IFRS requirements.
The earnings approach is used in ASPE and includes four criteria for revenue recognition:
1) the seller has transferred the risks and rewards of ownership to the buyer, 2) the seller
164 Revenue
does not maintain any continuing managerial involvement or control over the goods, 3) there
is reasonable assurance regarding measurement of the consideration to be received and
the amount of goods that may be returned, and 4) collection of consideration is reasonable
assured. In many instances, the earnings approach will arrive at similar results as the contract
based approach of IFRS 15. In some cases, however, the results may be different. With long-
term construction contracts, the earnings approach allows for the completed contract method
to be used if there is no reasonable way to estimate progress or performance of the contract
consists of a single act.
References
CPA Canada. (2017). Part II, Section 3400. In CPA Canada Handbook. Toronto, ON: CPA
Canada.
CPA Canada. (2017). Part I, Section IFRS 15. In CPA Canada Handbook. Toronto, ON: CPA
Canada.
Marriage, M. (2014, November 9). US law firms line up investors to sue Tesco. Financial
Times. Retrieved from https://next.ft.com/content/4ff7ce62-669f-11e4-91ab-00144
feabdc0
Exercises
EXERCISE 5–1
PhreeWire Phones offers a number of plans to its mobile telephone customers. For example,
a customer can receive a free phone when signing a 3-year contract for airtime and data that
requires a monthly payment of $80. Alternately, the customer could pay $300 for the telephone
when signing a 2-year contract requiring monthly payments of $100.
Required: Determine the amount of revenue to be recognized each year under the two
different scenarios. Assume that the fair value of the telephone is $500 and the fair value
of the airtime and data is $600 per year.
EXERCISE 5–2
Refer to the previous question.
Required: Determine the amount of revenue to be recognized each year under the two
Exercises 165
different scenarios. Assume that the fair value of the telephone is indeterminable and the
fair value of the airtime and data is as indicated.
EXERCISE 5–3
Art Attack Ltd. ships merchandise on consignment to The Print Haus, a retailer of fine art
prints. The cost of the merchandise is $58,000, and Art Attack pays the freight cost of $2,200
to ship the goods to the retailer. At the end of the accounting period, The Print Haus notifies
Art Attack Ltd. that 80% of the merchandise has been sold for $79,000. The Print Haus retains
a 10% commission as well as $3,400, which represent advertising costs it paid, and remits the
balance owing to Art Attack Ltd.
Required: Complete the journal entries required by each company for the above transactions.
EXERCISE 5–4
Eames Fine Furniture sells high quality, roll-top desks. The company allows customers to
return products for a full refund within 90 days of purchase. The desks sell for $3,000 and cost
the company $2,000 to manufacture. The company expects that any returned desks can be
resold for a profit. The company has reviewed historical financial data and determined that
0.5% of all desks sold are returned for a refund. During the month of January, the company
sold 800 desks.
Required:
a. Prepare all the required journal entries to record the January sales.
b. Assume one desk was actually returned by the end of January. Prepare the journal entry
required to record the return and describe the appropriate accounting treatment of any
further returns.
EXERCISE 5–5
Frank Ledger, a non-designated accountant, has agreed to provide twelve months of book-
keeping services to Digital Dreams Inc. (DDI), a computer equipment and accessories retailer.
Mr. Ledger will compile the accounting records of DDI every month and provide an unaudited
financial statement. Mr. Ledger has agreed not to invoice DDI during the year, and DDI has
agreed to provide Mr. Ledger with a free computer system. The computer would normally sell
for $3,000. Mr. Ledger has indicated that he would typically charge approximately $250/month
for similar bookkeeping services, although the actual amount invoiced per month would depend
on the volume of transactions and a number of other factors.
166 Revenue
Required: Assume the contract described above is signed on October 1 and Mr. Ledger’s fiscal
year end is December 31. Prepare all the required journal entries for Mr. Ledger between these
two dates.
EXERCISE 5–6
Suarez Ltd. entered into a contract on January 1, 2020, to construct a small soccer stadium
for a local team. The total fixed price for the contract is $35 million. The job was completed in
December 2021. Details of the project are as follows:
2020 2021
Costs incurred in the period $20,000,000 $11,000,000
Estimated costs to complete the project 10,000,000 -
Customer billings in the period 18,000,000 17,000,000
Cash collected in the period 17,000,000 15,000,000
Required:
a. Calculate the amount of gross profit to be recognized each year using the percentage-
of-completion method.
b. Prepare all the required journal entries for both years.
EXERCISE 5–7
In 2021, Gerrard Enterprises Inc. was contracted to build an apartment building for $5.2 million.
The project was expected to take three years and Gerrard estimated the costs to be $4.3
million. Actual results from the project are as follows:
2021 2022 2023

Accumulated costs to date $1,100,000 $3,400,000 $4,500,000
Estimated costs to complete the project 3,200,000 1,000,000 -
Customer billings to date 1,500,000 3,300,000 5,200,000
Cash collected to date 1,000,000 3,000,000 5,200,000
Required:
Exercises 167
b. Show how the details of this contract would be disclosed on the balance sheet and
income statement in 2022.
EXERCISE 5–8
On February 1, 2020, Sterling Structures Ltd. signed a $3.5 million contract to construct an
office and warehouse for a small wholesale company. The project was originally expected to
be completed in two years, but difficulties in hiring a sufficient pool of skilled workers extended
the completion date by an extra year. As well, significant increases in the price of steel in the
second year resulted in cost overruns on the project. Sterling was able to negotiate a partial
recovery of these costs, and the total contract value was adjusted to $3.8 million in the second
year. Additional information from the project is as follows:
2020 2021 2022

Total contract value $3,500,000 $3,800,000 $3,800,000
Accumulated costs to date 800,000 2,400,000 3,900,000
Estimated costs to complete the project 2,100,000 1,600,000 -
Customer billings to date 1,000,000 2,100,000 3,800,000
Cash collected to date 1,000,000 2,000,000 3,800,000
Required:
b. Prepare all the required journal entries for 2021.
EXERCISE 5–9
Take the same set of facts as described in the previous question, except assume that there is
no reasonable way to estimate progress on the contract.
Required:
a. Using the zero-margin method (IFRS), determine the amount of revenue and expense
to report each year.
b. Using the completed-contract method (ASPE), determine the amount of revenue and
expense to report each year.
Chapter 6
Cash and Receivables
Cash Overflows for Apple
In 2013, Apple advised their shareholders that it sold 34M iPhones, up 90% from the same
quarter last year, and up 150% from the year before. Along with the increased sales came
increased profits (almost double) and increased cash in the bank; about US$ 9.9B in cash
flow from operations for a total cash holding of about US$ 100B.
Until that point, Apple was reluctant to pay out dividends to its shareholders as most high-
tech companies need large amounts of cash to expand their existing markets and for
research and development costs to find new markets. In 2013, Tim Cook, CEO of Apple
Inc., convinced Apple’s board of directors that it was time to start paying out some periodic
cash dividends to its investors; US$ 3.05 per share. Dividend payouts, along with some
shares repurchases, totalled about US$ 7.8B paid to investors in the third quarter of 2013.
Since Apple is a multinational corporation operating globally, some of this cash stockpile
was in foreign funds. This strategy avoids paying the 35% US tax on foreign earnings
repatriation. In all, about two-thirds of its cash holdings are in foreign currencies. Even
though this cash is not available for dividends, this does not seem to bother Apple, since
the company seems to have more than enough US cash for dividends payments and other
return of capital. Even so, all this currency, especially foreign currency, is creating a new
problem.
At this rate of continued growth, many analysts are predicting a continued piling up of
foreign and US cash. The issue then becomes; what to do with all this cash, especially
the massive two-thirds portion of foreign cash? It has become a conundrum—to manage
all this cash, Apple has had to open about two hundred different bank accounts across
different banks to monitor and track cash locations and spending, as well as to track and
manage liquidity across the organization on a day-to-day basis.
The risk to their gigantic cash pile sitting in bank accounts is that it may be earning
simple interest instead of better rates from investing in higher yielding instruments such
as money market funds. For a cash-rich company such as Apple, a centralized cash
management system is crucial; it will provide information quickly and efficiently so that
Apple’s money managers can make critical (and timely) investment decisions. Another
benefit of a centralized cash repository is reduced risk of fraudulent access to cash, since
cash invested in money market funds and similar alternatives is less accessible than cash
sitting in a bank account, or many bank accounts as is the case with Apple.
In Apple’s case, a centralized cash treasury will add value by reducing the percentage of
169
170 Cash and Receivables
idle cash through streamlining bank accounts and by allowing cash managers to focus on
ensuring the right levels of cash with the remainder invested in instruments with better
returns.
While some may consider too much cash in too many bank accounts to be an enviable
position, it is still a risk that could lead to cash opportunities lost or worse, cash leaking
away in inappropriate hands if left unexamined.
(Source: Apple Inc., 2013)
LO 1: Describe cash and receivables, and explain their role in accounting and business.
LO 2: Describe cash and cash equivalents, and explain how they are measured and re-
ported.
LO 2.1: Explain the purpose and key activities of internal control for cash.
LO 3: Describe receivables, identify the different types of receivables, explain their account-
ing treatment, and prepare the relevant journal entries.
LO 3.1: Describe accounts receivable, and explain how they are initially and subsequently
measured and reported.
LO 3.2: Describe notes receivables, and explain how they are initially and subsequently
measured and reported.
LO 3.3: Describe derecognition of receivables and the various strategies businesses use
to shorten the credit-to-cash cycle through sales of receivables or borrowings
secured by receivables.
LO 3.4: Describe how receivables are disclosed on the balance sheet and in the notes.
LO 4: Identify the different methods used to analyze cash and receivables.
LO 5: Explain the differences between IFRS and ASPE for recognition, measurement, and
reporting for cash and receivables.
Introduction 171
Introduction
As the opening story about Apple illustrates, actively managing cash and receivables has
important implications for businesses. The time frame required to convert receivables to cash
is a cycle that calls for regular monitoring. This chapter addresses how management uses
financial reporting to regularly assess both the credit-to-cash cycle and its overall cash position
in terms of liquidity (the availability of liquid assets to pay short-term obligations as they come
due) or solvency (the ability to meet all maturing obligations as they come due). This chapter
will focus on cash, cash equivalents, accounts receivable, and notes (loans) receivable. Each
of these will be discussed in terms of their use in business: their recognition, measurement,
reporting, and analysis.
1.0 Cash and

Receivables: Overview
2.0 Cash and

Cash Equivalents Internal Control of Cash
Accounts Receivable
Notes Receivable
Cash and Receivables 3.0 Receivables
Derecognition and
Sales of Receivables
4.0 Cash and
Receivables: Analysis Disclosures of Receivables
5.0 IFRS/ASPE
Key Differences
A. Review of Internal
Controls, Petty Cash,
and Bank Reconciliations
6.1 Overview
Cash and receivables are financial assets. Specifically, cash, cash equivalents, accounts
receivable, and notes receivable are all considered to be financial assets because they are
either:
• Cash
• A contractual right to receive cash or another financial asset, from another entity (such
as accounts and notes receivable).
A financial asset derives its value because of a contractual right, or a claim for a determinable
amount. The physical paper that cash or receivables are printed on has no value by itself.
Their real value is based on what they represent. For example, financial assets such as cash
include foreign currencies because their value in Canadian dollars is determinable by applying
the current exchange rate. Receivables result from the sale of goods and services on credit or
through lendings, for which the amount has been fixed or known (determinable) at the time of
the transaction. In contrast, the cash value is not known in advance for non-financial assets
such as inventories and fixed assets because their cash value will depend on future market
conditions.
Cash and receivables are also monetary assets because they represent a claim to cash where
the amount is fixed by contract.
6.2 Cash and Cash Equivalents
Recognition, Measurement, and Disclosure
Cash is the most liquid of the financial assets and is the standard medium of exchange for
most business transactions.
Cash is usually classified as a current asset and includes unrestricted:
• Coins and currency, including petty cash funds
• Bank accounts funds and deposits
• Negotiable instruments such as money orders, certified cheques, cashiers’ cheques,

personal cheques, bank drafts, and money market funds with chequing privileges.
6.2. Cash and Cash Equivalents 173
Cash can be classified as a long-term asset if they are designated for specific purposes such
as a plant expansion project, or a long-term debt retirement, or as collateral.
Petty cash funds are classified as cash because these funds are used to meet current oper-
ating expenses and to pay current liabilities as they come due. Even though petty cash has
been set aside for a particular purpose, its balance is not material, so it is included in the cash
balance in the financial statements.
Excluded from cash are:
• Post-dated cheques from customers and IOUs (informal letters of a promise to pay a
debt), which are classified as receivables
• Travel advances granted to employees, which are classified as either receivables or

prepaid expenses
• Postage stamps on hand, which are classified as either office supplies (asset) or prepaid
expenses (asset)
Restricted Cash and Compensating Balances
Restricted cash and compensating balances are reported separately from regular cash if the
amount is material. Any legally restricted cash balances are to be separately disclosed and
reported as either a current asset or a long-term asset, depending on the length of time the
cash is restricted and whether the restricted cash offsets a current or a long-term liability.
In practice, many companies do not segregate restricted cash but disclose the restrictions
through note disclosures.
A compensating balance is a minimum cash balance in a company’s chequing or savings

account as support for a loan borrowed from a bank (or other lending institution). By requiring
a compensating balance, the bank can use the restricted funds that must remain on deposit
to invest elsewhere resulting in a better rate of return to the bank than the stated interest rate
(also called a face rate) of the loan itself.
Foreign Currencies
Many companies have bank accounts in other countries, especially if they are doing a lot of
business in those countries. A company’s foreign currency is reported in Canadian dollars at
the exchange rate at the date of the balance sheet.
For example, if a company had cash holdings of US $85,000 during the year at a time when
the exchange rate was US $1.00 = Cdn $1.05, at the end of the year when the exchange rate
had changed to US $1.00 = Cdn $1.11, the US cash balance would be reported on the balance
sheet in Canadian funds as $94,350 ($85,000 × $1.11). Since the original transaction would
have been recorded at Cdn $1.05, the adjusting entry would be for the difference in exchange
rates since that time, or $5,100 ($85,000 × ($1.11 − $1.05)):
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,100
Gain on foreign exchange . . . . . . . . . . . . . . . . . . 5,100
(US $85,000 × ($1.11 − $1.05))
Usually, this cash is included in current assets. However, if the cash flow out of the country is
restricted, the cash is treated in the accounts as restricted and reported separately.
Bank Overdrafts
Bank overdrafts (a negative bank balance) can be netted and reported with cash on the
balance sheet if the overdraft is repayable on demand and there are other positive bank
balances in the same bank for which the bank has legal right of access to settle the overdraft.
Otherwise, bank overdrafts are to be reported separately as a current liability.
Cash Equivalents
Cash equivalents are short-term, highly liquid assets that can readily be converted into known
amounts of cash and with little risk of price fluctuations. An example of a short-term cash
equivalent asset would be one that matures in three months or less from the acquisition
date. They may be considered as “near-cash,” but are not treated as cash because they
can include a penalty to convert back to cash before they mature. Examples are treasury
bills (T-bills), money market funds, short-term notes receivable, and guaranteed investment
certificates (GICs). For companies using ASPE, equities investments are usually not reported
as cash equivalents. For IFRS, preferred shares that are acquired within three months of their
specified redemption date can be included as cash equivalents.
Disclosures of Cash and Cash Equivalents
Cash equivalents can be reported at their fair value, together with cash on the balance sheet.
Fair value will be their cost at acquisition plus accrued interest to the date of the balance sheet.
Below is a partial balance sheet from Orange Inc. that shows cash and cash equivalents as at
December 31, 2020 along with the corresponding notes:
6.2. Cash and Cash Equivalents 175
CONSOLIDATED BALANCE SHEETS

(in millions)
December 31 December 31
2020 2019
ASSETS:
Current assets:
Cash and cash equivalents $ 18,050 $ 12,652
Short-term marketable securities 36,800 27,000
Financial Instruments
Cash Equivalents and Marketable Securities
All highly liquid investments with maturities of three months or less at the date of purchase
are classified as cash equivalents and are combined and reported with Cash. Management
determines the appropriate classification of its investments at the time of purchase and reeval-
uates the designations at each balance sheet date. For example, the Company classifies
its marketable debt securities as either short term or long term based on each instrument’s
underlying contractual maturity date. If they have maturities of 12 months or less, they are
classified as short term. Marketable debt securities with maturities greater than 12 months
are classified as long term. The Company classifies its marketable equity securities, including
mutual funds, as either short term or long term based on the nature of each security and its
availability for use in current operations. The Company’s marketable debt and equity securities
are carried at fair value, with the unrealized gains and losses, reported either as net income or,
net of taxes, as a component of shareholders’ equity (IFRS 9). The cost of securities sold is
based on the specific identification model. This will be discussed in more detail in Chapter 8,
Investments.
Effective cash management includes strong internal controls and a strategy to invest any
excess cash into short-term instruments that will provide a reasonable return in interest income
but still be quickly convertible back into cash, if required.
Summary of Cash, Cash Equivalents, and Other Negotiable Instruments

Asset Classification Description and Examples
Cash (current asset) Unrestricted: coins, currency, foreign curren-
cies, petty cash, bank funds, money orders,
cheques, and bank drafts
Cash equivalent (current asset) Short-term commercial paper, maturing
three months or less at acquisition, such
as T-bills, money market funds, short-term
notes receivable, GICs
Cash (long-term asset) Cash funding set aside for plant expansion,
or long-term debt retirement, or collateral
Cash (current or long-term asset) Separate reporting for legally restricted cash
and compensating bank balances
Receivables (current or long-term asset) Post-dated cheques, IOUs, travel advances
Office supplies inventory (current asset) Postage on hand
Bank indebtedness (current liability) Bank overdraft accounts not offset by same
bank positive balances
6.2.1 Internal Control of Cash
A key part of effective cash management is the internal control of cash. This topic was
introduced in the introductory accounting course. Below are some highlights regarding internal
control.
The purpose of effective financial controls is to:
• Protect assets
• Ensure reliable recognition, measurement, and reporting
• Promote efficient operations
• Encourage compliance with company policies and practices
The control of cash includes implementing internal controls over:
• The physical custody of cash on hand, including adequate levels of authority required for
all cash-based transactions and activities
• The separation of duties regarding cash
• Maintaining adequate cash records, including petty cash and the preparation of regular
bank reconciliations.
Controlling the physical custody of cash plays a key role in effective cash management. In the
opening story, Apple consolidated its bank accounts to a more manageable number, converted
its idle cash into less accessible commercial paper that earned interest, and implemented a
robust financial reporting system that would provide reliable and timely information about its
cash position.
Refer to 6.6 Appendix A: for a review of internal controls, petty cash, and bank reconciliations
taken from an introductory financial accounting textbook.
6.3. Receivables 177
6.3 Receivables
Receivables are asset accounts applicable to all amounts owing, unsettled transactions, or
other monetary obligations owed to a company by its credit customers or debtors. These are
contractual rights that have future benefits such as future cash flows to the company. These
accounts can be classified as either a current asset, if the company expects them to be realized
within one year or as a long-term asset, if longer than one year.
Typical receivable-related categories include:
• Accounts (trade) receivable—amounts owed by customers for goods or services sold

by a company on credit in the normal course of business. The transaction document is
typically called an invoice.
• Notes receivable—more formal, unconditional written promises to pay a specified amount

of money on a specified future date or on demand. The transaction document is usually
referred to as a promissory note.
• Non-trade receivable—arise from any number of other sources such as income tax
refunds, GST/HST taxes receivable, amounts due from the sale of assets, insurance
claims, advances to employees, amounts due from officers, and dividends receivable.
These are generally classified and reported as separate items in the balance sheet or in
a note that is cross-referenced to the balance sheet statement.
The illustration below shows a portion of the balance sheet for cash and cash equivalents and
various receivables on the financial statements:
Consolidated Balance Sheet

As of December 31, 2020 and 2019
(In millions of dollars except share amounts)
2020 2019
ASSETS
Cash and cash equivalents 3,500 4,200
Marketable securities 1,500 1,400
Receivables from affiliates 30 60
Trade accounts and notes receivables (net) 3,800 3,800
Financing receivables (net) 25,500 22,200
Financing receivables, securitized (net) 4,200 3,200
Other receivables 1,000 1,500
Operating leases receivables (net) 3,000 2,500
Receivables Management
It is important to consider carefully how to manage and control accounts receivable balances.
If credit policies are too restrictive, potential sales could be lost to competitors. If credit policies
are too flexible, more sales to higher risk customers may occur, resulting in more uncollectible
accounts. The bottom line is that receivables management is about finding the right level of
receivables to maintain when implementing the company’s credit policies.
As part of a credit assessment process, companies will initially assess the individual creditwor-
thiness of new customers and grant them a credit limit consistent with the level of assessed
credit risk. After the initial assessment, a customer’s payment history will affect whether their
credit limit will change or be revoked.
To lessen the risk of uncollectible accounts and improve cash flows, some companies will
adopt a policy that offers:
• Cash discounts to encourage cash sales

• Sales discounts to encourage faster payments of amounts owing on credit
• Late payment interest charges for any overdue accounts
Other management strategies can be implemented to shorten the receivables to cash cycle.
In addition to the discounts or late payment fees listed above, small- and medium-sized com-
panies may decide to sell their accounts receivable to financial intermediaries (factors). This
will convert the receivables into cash more quickly than if they waited for customers to pay.
Larger companies may rely on another way of selling receivables, called securitization. This
will be discussed later in this chapter.
Receivables management involves developing sound business practices for overall monitoring
as well as early detection of potential uncollectible accounts. Key activities include:
• Regular analysis of aged accounts receivable

• Regularly scheduled assessments and follow up on overdue accounts
6.3.1 Accounts Receivable
Recognition and Measurement of Accounts Receivable
Accounts receivable result from credit sales in the normal course of business (called trade
receivables) that are expected to be collected within one year. For this reason, they are
classified as current receivables on the balance sheet and initially measured at the time of
the credit sale at their net realizable value (NRV). Net realizable value (NRV) is the amount
expected to be received from the customer. IFRS and ASPE standards both allow NRV to
approximate the fair value, since the interest component is immaterial when determining the
present value of cash flows for short-term accounts receivable. In subsequent accounting
periods, accounts receivable are to be measured at their amortized cost which is the same as
cost, since there is no present value interest component to recognize. For long-term notes and
loans receivable that have an interest component, the asset’s carrying amount is measured at
amortized cost which will be described later in this chapter.
The valuation of the account receivable is also affected by:
• Trade and sales discounts
• Sales returns and allowances
Trade Discounts
Manufacturers and wholesalers publish catalogues with inventory and sales prices to assist
purchasers with their purchases. Catalogues are expensive to publish, so this is only done
from time to time. Sellers often offer trade discounts to customers to adjust the sales prices
of items listed in the catalogue. This can be an incentive to purchase larger quantities, as
a benefit of being a preferred customer or because costs to produce the items for sale have
changed.
Since the catalogue, or list, price is not intended to reflect the actual selling price, the seller
records the net amount after the trade discount is applied. For example, if a plumbing manu-
facturer has a catalogue or list price of $1000 for a bathtub and sells it to a plumbing retailer for
list price less a 20% trade discount, the sale and corresponding account receivable recorded
by the manufacturer is $800 per bathtub.
Sales Discounts
Sales discounts can be part of the credit terms for customers and are offered to encourage
faster payment of the account. The credit term 1.5/10, n/30 means there is a 1.5% discount if
the invoice is paid within ten days with the total amount owed due in thirty days.
Companies purchasing goods and services that do not take advantage of the sales discounts
are usually not using their cash as effectively as they could. For example, a purchaser who
fails to take the 1.5% reduction offered for payment within ten days for an account due in thirty
days is equivalent to missing a stated annual interest rate return on their cash for 27.38%
(365 days ÷ 20 days × 1.5%). For this reason, companies usually pay within the discount
period unless their available cash is insufficient to take advantage of the opportunity.
IFRS 15.53 – the term variable consideration, discussed in Chapter 5, Revenue, would also
include sales discounts because it is uncertain how many customers will actually take the sales
discount. For this reason, IFRS states that an estimate of “highly probable” sales discounts
expected to be taken by customers, needs to be determined and included at the time of
the sale. Given the high rate of return identified in the preceding paragraph, recording the
estimate immediately upon sale is conceptually sound and is consistent with the net method
described below. The standard suggests using either the expected value (a weighted average
of probabilities), or the “most likely amount” to estimate sales discounts, perhaps based on
past history.
To illustrate the net method, assume that Cramer Plumbing sells fifty bathtubs to a reseller
for $800 each, for a total sale of $40,000, with credit terms of 1.5/10, n/30. Using the net
method, Cramer expects that the sales discount will be taken by the purchaser; therefore,
Cramer Plumbing will record the following entry:
General Journal
Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39,400
($800 × 50 units × 98.5)
Note the reduction due to the sales discount is immediately recorded upon the sale. This re-
sults in the accounts receivable being valued at its net realizable value and based on Cramer’s
“more likely than not” estimate of sales discounts expected to be taken, which is consistent
with IFRS 15.53.
If $10,000 of the account receivable is collected from the reseller within the ten-day discount
period (for a cash amount of $9,850), the entry would be:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,850
($10,000 × 1.5%)
The entry for collection of the remaining amount owing for $30,000 after the discount period
is:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000
Sales discounts forfeited . . . . . . . . . . . . . . . . . . . 450
For Sales discount forfeited: ($30,000 × 1.5%)
As can be seen above, the net method records and values the accounts receivable at its
lowest, or net realizable value of $39,400, or gross sales for $40,000 less the 1.5% discount.
The gross method is much easier and ASPE can choose either method. For the gross method,
sales are recorded at the gross amount with no discount taken. If the customer pays within
the discount period, the applicable discount taken is recorded to a sales discounts account.
Any payments made after the discount period are simply the cash amount collected and no
calculation for the sales discounts forfeited is required.
Using the same example, assume that Cramer Plumbing sells fifty bathtubs for $800 each,
with credit terms of 1.5/10, n/30. Using the gross method, the entry for the sale is:
General Journal
Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000
($800 × 50 units)
The entry on collection of $10,000 within the ten-day discount period is:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,850
Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
For Sales discounts (a contra sales revenue
account): ($10,000 × 1.5%)
The entry on collection of the remaining $30,000 after the discount period is:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000
Note how the accounts receivable would not be reported at its net realizable value with this
method. If discounts are significant, this would overstate accounts receivable and sales in
the financial statements. For this reason, if the gross method is used and it is expected that
significant cash discounts are likely to be taken by customers in the fiscal year, an asset
valuation account and an adjusting entry is required to ensure that accounts receivable, net
of the valuation account, will reflect its net realizable value.
At year-end, assume that $6 million of Cramer’s accounts receivable all have terms of 1.5/10,
n/30, and management expects that 60% of these accounts will be collected within the dis-
count period, which it deems to be significant. The unadjusted balance in the allowance for
sales discounts account (a contra account to accounts receivable) is $3,000 credit balance.
The year-end adjusting entry to update the accounts receivable allowance account with the
estimated sales discounts would be:
General Journal
Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51,000
Allowance for sales discounts . . . . . . . . . . . . . . 51,000
(($6,000,000 × 1.5% × 60%) − $3,000). (Al-
lowance for sales discounts is a contra accounts
receivable account)
Throughout the following year, the allowance account can be directly debited each time cus-
tomers take the discounts and is adjusted up or down at the end of each reporting period.
Sales Returns and Allowances
Many ASPE companies have policies that allow for the return of goods under certain circum-
stances and will refund all or a partial amount of the returned item’s cost.
Assuming that returns for this company are insignificant, the entry for a $1,000 sales return on
account (with a cost $800) returned to inventory, for a company using a perpetual inventory
system, would be:
General Journal
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800
COGS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800
Sales returns and allowances . . . . . . . . . . . . . . . . . 1,000
(Sales returns and allowances is a contra sales
revenue account)
Sales allowances are reductions in the selling price for goods sold to customers, perhaps due
to damaged goods that the customer is willing to keep if the sales price is reduced sufficiently.
For example, if a sales allowance of $2,000 is granted due to damaged goods that the cus-
tomer chose to keep, the entry, assuming sales allowances for this company are insignificant,
would be:
General Journal
Accounts receivable or cash . . . . . . . . . . . . . . . 2,000
(Sales returns and allowances is a contra sales
revenue account)
As was done with sales discounts, sales returns and allowances should be recognized in
the period of the sale to avoid overstating accounts receivable and sales. Sales returns and
allowances are therefore estimated and adjusted at the end of each reporting period. If the
amount of returns and allowances is not material a year-end adjusting entry is not required
and the entries shown above would be sufficient, provided that it is handled consistently from
year to year. If returns and allowances are significant, an allowance for sales returns and
allowances account, which is an asset valuation account contra to accounts receivable, is
used to record the estimates.
For example, management estimates the total sales returns and allowances to be $51,500,
which it deems to be significant. If the company follows ASPE, and the unadjusted balance in
the allowance for sales returns and allowances account is $5,000 credit balance, the year-
end adjusting entry would be:
General Journal
Allowance for sales returns and allowances 46,500
($51,500 − $5,000) (Sales returns and al-
lowances is a contra sales revenue account and
Allowance for sales returns and allowances is a
contra accounts receivable account)
Note how another contra account, the sales returns and allowances account, is used to record
the debit entry for the previous two journal entries above. Its purpose is to track returns
and allowances transactions separately, as opposed to directly recording them as a debit to
sales. If amounts in this contra account become too high, it could indicate to management the
possibility of future sales lost due to unsatisfied customers.
During the reporting period, the allowance for sales returns and allowances asset valuation
account can be directly debited each time customers are granted returns or allowances. This
asset valuation account will subsequently be adjusted up or down at the end of each reporting
period.
Sales with right of return under IFRS has been discussed in Section 5.3.3, Sales With Right
of Return, where a detailed example is presented.
Estimating Allowance for Uncollectible Accounts
When accounts receivables exist, some amounts of uncollectible receivables are inevitable
due to credit risk. This risk is the likelihood of loss due to customers not paying their amounts
owing. If the uncollectible amounts are both likely and can be estimated, an amount for uncol-
lectible accounts must be estimated and recognized in the accounts to ensure that accounts
receivable and net income are not overstated over the lifetime of the accounts receivable (IFRS
9; lifetime expected credit losses). The allowance account, called the allowance for doubtful
accounts (AFDA), is an asset valuation account (contra account to accounts receivable), which
is used the same way as the Allowance for Sales Discounts discussed earlier.
Many companies set their credit policies to allow for a certain percentage of uncollectible
accounts. This is to ensure that the credit policy is not too restrictive or liberal, as explained in
the opening paragraph of the Receivables Management section of this chapter.
Measuring uncollectible amounts at the end of each reporting period involves estimates that
can be calculated using several methods:
• Percentage of accounts receivable method
• Accounts receivable aging method
• Credit sales method
• Mix of methods
The first three methods were covered in the introductory accounting course. Below is a review
of these methods. The mix of methods is perhaps a more realistic view of how companies
estimate bad debt expense over a reporting period.
For each method above, management estimates a percentage that will represent the likelihood
of collectability. The estimated total amount of uncollectible accounts is calculated and usually
recorded to the AFDA allowance account, with the offsetting entry to bad debt expense.
The net amount for accounts receivable and its contra account, the AFDA, reflects the net
realizable value of the accounts receivable at the reporting date.
Percentage of Accounts Receivable Method

For this method, the accounts receivable closing balance is multiplied by the percentage that
management estimates is uncollectible. This method is based on the premise that some
portion of accounts receivable will be uncollectible, and management uses reasonably avail-
able and supportable information (IFRS 9) regarding past experiences, current economic
conditions, and expected future conditions as a guide to the percentage used. For this reason,
the estimated amount of uncollectible accounts is to be equal to the adjusted ending balance
of the AFDA. The adjusting entry amount must therefore be the amount required that results
in that ending balance of the AFDA.
For example, assume that accounts receivable and the AFDA ending balances were $200,000
debit and $2,500 credit balances respectively at December 31, and the uncollectible accounts
is estimated to be 4% of accounts receivable. This means that the AFDA adjusted ending
balance is estimated to be the amount equal to 4% of $200,000, or $8,000. The adjusting
entry to achieve the correct AFDA adjusted ending balance of $8,000 would be:
General Journal
Bad debt expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,500
Allowance for doubtful accounts . . . . . . . . . . . . 5,500
(($200,000 × 4%) − $2,500)
The AFDA ending balance after the adjusting entry would correctly be $8,000
($2,500 unadjusted balance + $5,500 adjusting entry).
Sometimes the AFDA ending balance can be in a temporary debit balance due to a write-off
of an uncollectible account during the period. If this is the case, care must be taken to make
the correct calculations for the adjusting entry. For the example above, if the unadjusted AFDA
balance was a $300 debit balance, then the adjusting entry for uncollectible accounts would
be:
General Journal
Bad debt expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,300
(($200,000 × 4%) + 300)
The AFDA ending balance after the adjusting entry would correctly be $8,000 ($300 debit +
$8,300 credit).
Notice that the AFDA ending balance of $8,000 is the same for both examples when applying
the percentage of accounts receivable method. This is because the calculation is intended to
be an estimate of the AFDA ending balance, so the adjustment amount is whatever is required
to result in that ending balance.
Accounts Receivable Aging Method

Typically, the older the uncollected account, the more likely it is to be uncollectible. Following
this premise, the accounts receivable are grouped into categories based on the length of time
they have been outstanding.
Just as was done for the percentage of accounts receivable method above, companies will use
past experience to estimate the percentage of their outstanding receivables that will become
uncollectible for each aged group, such as the four aging groups identified in the schedule
below. The sum of all the estimated uncollectible amounts by group represents the total
estimated uncollectible accounts. Just like the percentage of accounts receivable method
previously discussed, the estimated amount of uncollectible accounts using this method is
to be equal to the ending balance of the AFDA account. The adjusting entry amount must
therefore be whatever amount is required to result in this ending balance.
Aging schedules are also a good indicator of which accounts may need additional attention
by management, due to their higher credit risk group, such as the length of time the account
has been outstanding or overdue.
Below is an example of an accounts receivable aging schedule:
Taylor and Company

Aging Schedule
Customer Balance Under 61–90 91–120 Over 120
Dec 31, 2020 60 days days days days
Abigail Holdings $3,500 $1,500 $2,000
Beaver Industries Inc. 45,000 25,000 8,500 $6,500 $5,000
Cambridge Instruments Co. 18,000 18,000
Dereck Station Ltd. 25,000 25,000
Falling Gate Repair 6,840 6,840
Gladstone Walkways Corp. 26,000 26,000
.. .. .. ..
. . . .
Tremsol Cladding Inc. 15,000 10,000 4,000 1,000
Warbling Water Pond Installations 6,480 1,480 5,000
$186,480 $124,050 $22,300 $22,130 $18,000
Percent estimated uncollectible 5% 10% 15% 35%
Total Allowance for uncollectible
accounts ending balance $18,053 $6,203 $2,230 $3,320 $6,300
The analysis above indicates that Taylor and Company expects to receive $186,480 less
$18,053, or $168,427 net cash receipts from the December 31 amounts owed. The $168,427
represents the company’s estimated net realizable value of its accounts receivable and this
amount would be reported as the net accounts receivable in the balance sheet as at December
31.
Assuming the data above for Taylor and Company and an unadjusted AFDA credit balance as
at December 31 of $2,500, the adjusting entry for uncollectible accounts would be:
General Journal
Bad debt expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,553
($18,053 − $2,500)
As was illustrated for the percentage of accounts receivable method above, the calculation of
the adjusting entry amount must consider whether the unadjusted AFDA balance is a debit or
credit amount.
Credit Sales Method
This is the easiest method to apply. The amount of credit sales (or total sales, if credit sales are
not determinable) is multiplied by the percentage that management estimates is uncollectible.
Factors to consider when determining the percentage amount to use will be trends resulting
from amounts of uncollectible accounts in proportion to credit sales experienced in the past.
The resulting amount is credited to the AFDA account and debited to bad debt expense.
Note that for this method, the previous balance in the AFDA account is not taken into consid-
eration. This is because the credit sales method is intended to calculate the bad debt expense
that will be reported in the income statement. This is a fast and simple way to estimate bad
debt expense because the amount of sales (or preferably credit sales) is known and readily
available. This method also illustrates proper matching of expenses with revenues earned over
that reporting period.
For example, if credit sales were $325,000 at the end of the period and the uncollectible
accounts was estimated to be 3% of credit sales, the entry would be:
General Journal
Bad debt expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,750
($325,000 × 3%) (Allowance for doubtful ac-
counts is a contra accounts receivable account)
Mix of Methods
Often companies will use the percentage of credit sales method to adjust the net accounts
receivables for interim (monthly) financial reporting purposes because it is easy to apply. At
the end of the year, either the percentage of accounts receivable or aging accounts receivable
method is used for purposes of preparing the year-end financial statements so that the AFDA
account is adjusted accordingly, and reported on the balance sheet.
Below is a partial balance sheet for Taylor and Company using the data from the Accounts
Receivable Aging Method section above:
Taylor and Company

Balance Sheet
December 31, 2020
Current assets:
Less: Allowance for doubtful accounts 18,053
$168,427
To summarize, the $186,480 represents the total amount of trade accounts receivables owing
from all the credit customers at the reporting date of December 31, 2020. The $18,053
represents the estimated amount of uncollectible accounts calculated using the allowance
method, the percentage of sales method, or a mix of methods. The $168,427 represents the
net realizable value (NRV) of the receivable at the reporting date.
Write-offs and Collections
Write-off of an Actual Uncollectible Account
Management may deem that a customer’s account is uncollectible and may wish to remove
the account balance from accounts receivable with the offsetting entry to the allowance for
doubtful accounts. For example, using the data for Taylor and Company shown under the
accounts receivable aging method, assume that management wishes to remove the account
for Cambridge Instruments Co. of $18,000 because it remains unpaid despite efforts to collect
the account. The entry to remove the account from the accounting records is:
General Journal
Allowance for doubtful accounts . . . . . . . . . . . . . . . 18,000
Because the AFDA is a contra account to accounts receivable, and both have been reduced
by identical amounts, there is no effect on the net accounts receivable (NRV) on the balance
sheet. This treatment and entry makes sense because the estimate for uncollectible accounts
adjusting entry (with a debit to bad debt expense) had already been done using one of the
allowance methods discussed earlier. The purpose of the write-off entry is to simply remove
the account from the accounting records.
Collection of a Previously Written-off Account
Even though management at Taylor and Company thinks that the collection of the $18,000
account has become unlikely, this does not mean that the company will make no further efforts
to collect the amount outstanding from the purchaser. During the tough economic times in
2009 and onward, many companies were in such financial distress that they were simply
unable to pay their amounts owing. Many of their accounts had to be written-off by suppliers
during that time as companies struggled to survive the crisis. Some of these companies
recovered through good management, and cash flows returned. It is important for these
companies to rebuild their relationships with suppliers they had previously not paid. So, it
is not uncommon for these companies, after recovery, to make efforts to pay bills that the
supplier had previously written-off.
As a result, a supplier may be fortunate enough to receive some or all of a previously written-off
account from a customer. When this happens, a two-step process accounts for the payment:
1. Reinstate the account receivable amount being paid by reversing the previous write-off
entry for an amount equal to the payment now received.
2. Record the cash received as a collection of the accounts receivable amount reinstated
in the first entry.
If Cambridge Instruments Co. pays $5,000 cash and indicates that this is all that the company
can pay of the original $18,000, the entry would be:
Step 1: Reinstate the account receivable upon receipt of cash (reversing a portion of the
write-off entry):
General Journal
Step 2: Record the receipt of cash on account from Cambridge Instruments:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Summary of Transactions and Adjusting Entries

An understanding of the relationships between the accounts receivable and the AFDA ac-
counts and the types of transactions that affect them are important for sound accounts analy-
sis. Below is an overview of some of the types of transactions that affect these accounts:
Transaction or Adjusting Entry: Accounts Allowance for

Receivable Doubtful Accounts
Debit Credit Debit Credit
Opening balance, assuming accounts have
normal balances 1) $$ 1) $$
Sale on account 2) $$ 2)
Cash receipts 3) $$ 3)
Customer account written-off 4) $$ 4) $$
Reinstatement of account previously

written-off 5) $$ 5) $$
Subtotal
End of period adjustment for uncollectible

accounts (debit to bad debt expense) 6) 6) $$
Closing balance, end of period $$ $$
Direct Write-off of Uncollectible Accounts
Some smaller companies may only have a few credit sales transactions and small accounts re-
ceivable balances. These companies usually use the simpler direct write-off method because
the amount of uncollectible accounts is deemed to be immaterial. This means that when a
specific customer account is determined to be uncollectible, the account receivable for that
customer account is written-off with the debit entry recorded to bad debt expense as shown in
the following entry:
General Journal
Bad debt expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $$
Accounts receivable, S. Smith . . . . . . . . . . . . . . $$
If the uncollectible account written-off is subsequently collected at some later date, the entry
would be:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $$
Bad debt expense or uncollectible amount $$
recovered, S. Smith (Income statement) . . . . . . .
If the uncollectible amounts were material, it would not be appropriate to use the direct write-off
method, for many reasons:
• Without an estimate for uncollectible accounts, net account receivables would be re-
ported at an amount higher than their net realizable value.
• The write-off of the uncollectible account will likely occur in a different year than the
sale, which will create over- and under-statements of net income over the affected years
resulting in non-compliance of the matching principle.
• Direct write-off creates an opportunity to manipulate asset amounts and net income. For
example, management might delay a direct write-off to keep net income high artificially
if this will favourably affect a bonus payment.
This section of the chapter is intended to be a summary overview of the methods and entries
used to estimate and write-off uncollectible accounts originally covered in detail in the intro-
ductory accounting course. Students may wish to review those learning concepts from that
course.
6.3.2 Notes Receivable
Recognition and Measurement of Notes Receivable
A note receivable is an unconditional written promise to pay a specific sum of money on

demand or on a defined future date and is supported by a formal written promissory note.
For this reason, notes are negotiable instruments the same as cheques and bank drafts.
Notes receivable can arise due to loans, advances to employees, or from higher-risk customers
who need to extend the payment period of an outstanding account receivable. Notes can
also be used for sales of property, plant, and equipment or for exchanges of long-term assets.
Notes arising from loans usually identify collateral security in the form of assets of the borrower
that the lender can seize if the note is not paid at the maturity date.
Notes may be referred to as interest-bearing or non-interest-bearing:
• Interest-bearing notes have a stated rate of interest that is payable in addition to the face
value of the note.
• Notes with stated rates below the market rates or zero- or non-interest-bearing notes
may or may not have a stated rate of interest. This is usually done to encourage sales.
However, there is always an interest component embedded in the note, and that amount
will be equal to the difference between the amount that was borrowed and the amount
that will be repaid.
Notes may also be classified as short-term (current) assets or long-term assets on the balance
sheet:
• Current assets: short-term notes that become due within the next twelve months (or
within the business’s operating cycle if greater than twelve months);
• Long-term assets: notes are notes with due dates greater than one year.
Cash payments can be interest-only with the principal portion payable at the end or a mix of
interest and principal throughout the term of the note.
Notes receivable are initially recognized at the fair value on the date that the note is legally
executed (usually upon signing). Subsequent valuation is measured at amortized cost.
Transaction Costs
It is common for notes to incur transactions costs, especially if the note receivable is acquired
using a broker, who will charge a commission for their services. For a company using either
ASPE or IFRS, the transaction costs associated with financial assets such as notes receivable
that are carried at amortized cost are to be capitalized which means that the costs are to be
added to the asset’s fair value of the note at acquisition and subsequently included with any
discount or premium and amortized over the term of the note.
Short-Term Notes Receivable
When notes receivable have terms of less than one year, accounting for short-term notes is
relatively straight forward as discussed below.
Calculating the Maturity Date
Knowing the correct maturity date will have an impact on when to record the entry for the note
and how to calculate the correct interest amount throughout the note’s life. For example, to
calculate the maturity date of a ninety-day note dated March 14, 2020:
Total days in March 31
Minus date of note 14
Days in March 17
Days in April 30
Days in May 31
Days in June to equal 90 days 12 Maturity date is June 12, 2020
Period of note 90
For example, assume that on March 14, 2020, Ripple Stream Co. accepted a ninety-day,
8% note of $5,000 in exchange for extending the payment period of an outstanding account
receivable of the same value. Ripple’s entry to record the acceptance of the note that will
replace the accounts receivable is:
General Journal
Mar 14 Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
The entry for payment of the note ninety days at maturity on June 12 would be:
General Journal
Jun 12 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,098.63
Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000.00
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98.63
For Interest income: ($5,000 × .08 × 90 ÷ 365)
In the example above, if financial statements are prepared during the time that the note
receivable is outstanding, interest will be accrued to the reporting date of the balance sheet.
For example, if Ripple’s year-end were April 30, the entry to accrue interest from March 14 to
April 30 would be:
General Journal
Apr 30 Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51.51
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51.51
($5,000 × .08 × 47 ÷ 365) (Mar 31 − 14 =
17 days + Apr = 30 days)
When the cash payment occurs at maturity on June 12, the entry would be:
General Journal
Jun 12 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,098.63
Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . 51.51
Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000.00
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47.12
For Interest income: (($5,000 × .08 × 90 ÷
365) − $51.51)
The interest calculation will differ slightly had the note been stated in months instead of days.
For example, assume that on January 1, Ripple Stream accepted a three-month (instead
of a ninety-day), 8%, note in exchange for the outstanding accounts receivable. If Ripple’s
year-end was March 31, the interest accrual would be:
General Journal
Mar 31 Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100.00
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100.00
($5,000 × .08 × 3 ÷ 12)
Note the difference in the interest calculation between the ninety-day and the three-month
notes recorded above. The interest amounts differ slightly between the two calculations be-
cause the ninety-day note uses a 90/365 ratio (or 24.6575% for a total amount of $98.63) while
the three-month note uses a 3/12 ratio (or 25% for a total of $100.00).
Receivables, Interest, and the Time Value of Money
All financial assets are to be measured initially at their fair value which is calculated as the
present value amount of future cash receipts. But what is present value? It is a discounted
cash flow concept, which is explained next.
It is common knowledge that money deposited in a savings account will earn interest, or money
borrowed from a bank will accrue interest payable to the bank. The present value of a note
receivable is therefore the amount that you would need to deposit today, at a given rate of
interest, which will result in a specified future amount at maturity. The cash flow is discounted
to a lesser sum that eliminates the interest component—hence the term discounted cash flow.
The future amount can be a single payment at the date of maturity or a series of payments over
future time periods or some combination of both. Put into context for receivables, if a company
must wait until a future date to receive the payment for its receivable, the receivable’s face
value at maturity will not be an exact measure of its fair value on the date the note is legally
executed because of the embedded interest component.
For example, assume that a company makes a sale on account for $5,000 and receives a
$5,000, six-month note receivable in exchange. The face value of the note is therefore $5,000.
If the market rate of interest is 9%, or its value without the interest component, is $4,780.79
and not $5,000. The $4,780.79 is the amount that if deposited today at an interest rate of 9%
would equal $5,000 at the end of six months. Using an equation, the note can be expressed
as:
(0 PMT, .75% I/Y, 6 N, 5000 FV)
Where I/Y is interest of .75% each month (9%/12 months) for six months.
N is for interest compounded each month for six months.
FV is the payment at the end of six months’ time (future value) of $5,000.
To summarize, the discounted amount of $4,780.79 is the fair value of the $5,000 note at the
time of the sale, and the additional amount received after the sale of $219.21 ($5,000.00 −
$4,780.79) is interest income earned over the term of the note (six months). However, for any
receivables due in less than one year, this interest income component is usually insignificant.
For this reason, both IFRS and ASPE allow net realizable value (the net amount expected
to be received in cash) to approximate the fair value for short-term notes receivables that
mature within one year. So, in the example above, the $5,000 face value of the six-month
note will be equivalent to the fair value and will be the amount reported, net of any estimated
uncollectability (i.e. net realizable value), on the balance sheet until payment is received.
However, for notes with maturity dates greater than one year, fair values are to be determined
at their discounted cash flow or present value, which will be discussed next.
Long-Term Notes Receivable
The difference between a short-term note and a long-term note is the length of time to maturity.
As the length of time to maturity of the note increases, the interest component becomes
increasingly more significant. As a result, any notes receivable that are greater than one
year to maturity are classified as long-term notes and require the use of present values to
estimate their fair value at the time of issuance. After issuance, long-term notes receivable are
measured at amortized cost. Determining present values requires an analysis of cash flows
using interest rates and time lines, as illustrated next.
Present Values and Time Lines
The following timelines will illustrate how present value using discounted cash flows works.
Below are three different scenarios:
1. Assume that on January 1, Maxwell lends some money in exchange for a $5,000, five-
year note, payable as a lump-sum at the end of five years. The market rate of interest is
5%. Maxwell’s year-end is December 31. The first step is to identify the amount(s) and
timing of all the cash flows as illustrated below on the timeline. The amount of money
that Maxwell would be willing to lend the borrower using the present value calculation of
the cash flows would be $3,917.63 as follows:
N = years 0 1 2 3 4 5
$5,000
Present Value (PV) = $3,917.63
PV = (0 PMT, 5 I/Y, 5 N, 5000 FV)

where I/Y is interest
N is # of periods
FV is future value
In this case, Maxwell will be willing to lend $3,917.63 today in exchange for a payment
of $5,000 at the end of five years at an interest rate of 5% per annum. The entry for the
note receivable at the date of issuance would be:
General Journal
Jan 1 Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,917.63
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,917.63
2. Now assume that on January 1, Maxwell lends an amount of money in exchange for a
$5,000, five-year note. The market rate of interest is 5%. The repayment of the note
is payments of $1,000 at the end of each year for the next five years (present value of
an ordinary annuity). The amount of money that Maxwell would be willing to lend the
borrower using the present value calculation of the cash flows would be $4,329.48 as
follows:
N = years 0 1 2 3 4 5
$1,000 $1,000 $1,000 $1,000 $1,000

$1000
(1.05)1 = $952.38
$1000
(1.05)2 = $907.03
$1000
(1.05)3 = $863.84
$1000
(1.05)4 = $822.70
$1000
(1.05)5 = $783.53
Present Value of an = $4,329.48

Ordinary Annuity
PV = (1000 PMT, 5 I/Y, 5 N, 0 FV)

where PMT is the payment amount
I/Y is the interest
N is the # of periods
FV is the single payment at maturity.
The entry for the note receivable would be:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,329.48
Note that Maxwell is willing to lend more money ($4,329.48 compared to $3,917.63) to
the borrower in this example. Another way of looking at it is that the interest component
embedded in the note is less for this example. This makes sense because the principal
amount of the note is being reduced over its five-year life because of the yearly payments
of $1,000.
3. How would the amount of the loan and the entries above differ if Maxwell received five
equal payments of $1,000 at the beginning of each year (present value of an annuity
due) instead of at the end of each year as shown in scenario 2 above? The amount of
money that Maxwell would be willing to lend using the present value calculation of the
cash flows would be $4,545.95 as follows:
N = years 0 1 2 3 4 5
$1,000 $1,000 $1,000 $1,000 $1,000

$1000
(1.05)0 = $1000.00
$1000
(1.05)1 = $952.38
$1000
(1.05)2 = $907.03
$1000
(1.05)3 = $863.84
$1000
(1.05)4 = $822.70
Present Value of an = $4,545.95

Annuity Due
PV = (1000 P/AD, 5 I/Y, 5 N, 0 FV)

where P/AD is the payment at the beginning of the period
I/Y is interest
N is # of periods
FV is a single payment at maturity.
The entry for the note receivable would be:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,545.95
Again, the interest component will be less because a payment is paid immediately upon
execution of the note, which causes the principal amount to be reduced sooner than a
payment made at the end of each year.
Below is a comparison of the three scenarios:
Scenario 1 Scenario 2 Scenario 3
Single payment Five payments of Five payments of

at maturity $1,000 at the end $1,000 at the beginning
of each month of each month
Face value of the note $5,000 $5,000 $5,000
Less: present value of the note 3,918 4,329 4,546
Interest component $1,082 $671 $454
Note that the interest component decreases for each of the scenarios even though the total
cash repaid is $5,000 in each case. This is due to the timing of the cash flows as discussed
earlier. In scenario 1, the principal is not reduced until maturity and interest would accrue over
the full five years of the note. For scenario 2, the principal is being reduced on an annual
basis, but the payment is not made until the end of each year. For scenario 3, there is an
immediate reduction of principal due to the first payment of $1,000 upon issuance of the note.
The remaining four payments are made at the beginning instead of at the end of each year.
This results in a reduction in the principal amount owing upon which the interest is calculated.
This is the same concept as a mortgage owing for a house, where it is commonly stated by
financial advisors that a mortgage payment split and paid every half-month instead of a single
payment once per month will result in a significant reduction in interest costs over the term of
the mortgage. The bottom line is: If there is less principal amount owing at any time over the
life of a note, there will be less interest charged.
Present Values with Unknown Variables
As is the case with any algebraic equation, if all variables except one are known, the final
unknown variable can be determined. For present value calculations, if any four of the five
variables in the following equation
PV = (PMT, I/Y, N, FV)
are known, the fifth “unknown” variable amount can be determined using a business calculator
or an Excel net present value function. For example, if the interest rate (I/Y) is not known, it
can be derived if all the other variables in the equation are known. This will be illustrated when
non-interest-bearing long-term notes receivable are discussed later in this chapter.
Present Values when Stated Interest Rates are Different than Effective (Market) Interest
Rates
Differences between the stated interest rate (or face rate) and the effective (or market) rate at
the time a note is issued can have accounting consequences as follows:
• If the stated interest rate of the note (which is the interest rate that the note pays) is 10%
at a time when the effective interest rate (also called the market rate, or yield) is 10% for
notes with similar characteristics and risk, the note is initially recognized as:
face value = fair value = present value of the note
This makes intuitive sense since the stated rate of 10% is equal to the market rate of
10%.
• If the stated interest rate is 10% and the market rate is 11%, the stated rate is lower than
the market rate and the note is trading at a discount.
If stated rate lower than market Present value lower Difference is a discount
• If the stated interest rate is 10% and the market rate is 9%, the stated rate is higher than
the market rate and the note is trading at a premium.
If stated rate higher than market Present value higher Difference is a premium
The premium or discount amount is to be amortized over the term of the note. Below are the
acceptable methods to amortize discounts or premiums:
• If a company follows IFRS, the effective interest method of amortization is required

(discussed in the next section).
• If a company follows ASPE, the amortization method is not specified, so either straight-
line amortization or the effective interest method is appropriate as an accounting policy
choice.
Long-Term Notes, Subsequent Measurement
Under IFRS and ASPE, long-term notes receivable that are held for their cash flows of principal
and interest are subsequently accounted for at amortized cost, which is calculated as:
• Amount recognized when initially acquired (present value) including any transaction
costs such as commissions or fees
• Plus interest and minus any principal collections/receipts. Payments can also be blended
interest and principal.
• Plus amortization of discount or minus amortization of premium
• Minus write-downs for impairment, if applicable
Below are some examples with journal entries involving various stated rates compared to
market rates.
1. Notes Issued at Face Value
Assume that on January 1, Carpe Diem Ltd. lends $10,000 to Fascination Co. in exchange for
a $10,000, three-year note bearing interest at 10% payable annually at the end of each year
(ordinary annuity). The market rate of interest for a note of similar risk is also 10%. The note’s
present value is calculated as:
Face value of the note $ 10,000

Present value of the note principal and interest:
Interest = $10,000 × 10% = $1,000 PMT
PV = (1000 PMT, 10 I/Y, 3 N, 10000 FV) 10,000
Difference $ 0
In this case, the note’s face value and present value (fair value) are the same ($10,000)
because the effective (market) and stated interest rates are the same. Carpe Diem’s entry
on the date of issuance is:
General Journal
Jan 1 Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
If Carpe Diem’s year-end was December 31, the interest income recognized each year would
be:
General Journal
Dec 31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
(10,000 × 10%)
2. Stated Rate Lower than Market Rate: A Discount
Assume that Anchor Ltd. makes a loan to Sizzle Corp. in exchange for a $10,000, three-year
note bearing interest at 10% payable annually. The market rate of interest for a note of similar
risk is 12%. Recall that the stated rate of 10% determines the amount of the cash received
for interest; however, the present value uses the effective (market) rate to discount all cash
flows to determine the amount to record as the note’s value at the time of issuance. The note’s
present value is calculated as:
Face value of the note $ 10,000

Present value of the note principal and interest:
Interest = $10,000 × 10% = $1,000 PMT
PV = (1000 PMT, 12 I/Y, 3 N, 10000 FV) 9,520
Difference $ 480
As shown above, the note’s market rate (12%) is higher than the stated rate (10%), so the note
is issued at a discount.
Anchor’s entry to record the issuance of the note receivable:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,520
Even though the face value of the note is $10,000, the amount of money lent to Sizzle would
only be $9,520, which is net of the discount amount and is the difference between the stated
and market interest rates discussed earlier. In return, Anchor will receive an annual cash
payment of $1,000 for three years plus a lump sum payment of $10,000 at the end of the third
year, when the note matures. The total cash payments received will be $13,000 over the term
of the note, and the interest component of the note would be:
Cash received $13,000

Present value (fair value) 9,520
Interest income component 3,480 (over the three-year life)
As mentioned earlier, if Anchor used IFRS the $480 discount amount would be amortized
using the effective interest method. If Anchor used ASPE, there would be a choice between
the effective interest method and the straight-line method.
Below is a schedule that calculates the cash received, interest income, discount amortization,
and the carrying amount (book value) of the note at the end of each year using the effective
interest method:
$10,000 Note Receivable Payment and Amortization Schedule

Effective Interest Method
Stated rate of 10% and market rate of 12%
Cash Interest Amortized Carrying
Received Income @12% Discount Amount
Date of issue $9,520
End of year 1 $1,000 $1,142* $142 9,662
End of year 2 1,000 1,159 159 9,821
End of year 3 1,000 1,179 179 10,000
End of year 3 final payment 10,000 - - 0
$13,000 $3,480 $480
* $9,520 × 12% = $1,142
The total discount $480 amortized in the schedule is equal to the difference between the face
value of the note of $10,000 and the present value of the note principal and interest of $9,250.
The amortized discount is added to the note’s carrying value each year, thereby increasing its
carrying amount until it reaches its maturity value of $10,000. As a result, the carrying amount
at the end of each period is always equal to the present value of the note’s remaining cash
flows discounted at the 12% market rate. This is consistent with the accounting standards for
the subsequent measurement of long-term notes receivable at amortized cost.
If Anchor’s year-end was the same date as the note’s interest collected, at the end of year 1
using the schedule above, Anchor’s entry would be:
General Journal
End of year 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Note receivable (discount amortized amount) . . 142
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,142
For Interest income: (9,520 × 12%)
Alternatively, if Anchor used ASPE the straight-line method of amortizing the discount is simple
to apply. The total discount of $480 is amortized over the three-year term of the note in equal
amounts. The annual amortization of the discount is $160 ($480 ÷ 3 years) for each of the
three years as shown in the following entry:
General Journal
End of year 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Note receivable (discount amortized amount) . . 160
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,160
Comparing the three years’ entries for both the effective interest and straight-line methods
shows the following pattern for the discount amortization of the note receivable:
Effective Interest Straight-Line

End of year 1 $142 $160
End of year 2 159 160
End of year 3 179 160
$480 $480
The amortization of the discount using the effective interest method results in increasing
amounts of interest income that will be recorded in the adjusting entry (decreasing amounts of
interest income for amortizing a premium) compared to the equal amounts of interest income
using the straight-line method. The straight-line method is easier to apply but its shortcoming
is that the interest rate (yield) for the note is not held constant at the 12% market rate as is
the case when the effective interest method is used. This is because the amortization of the
discount is in equal amounts and does not take into consideration what the carrying amount
of the note was at any given period of time. At the end of year 3, the notes receivable balance
is $10,000 for both methods, so the same entry is recorded for the receipt of the cash.
General Journal
End of year 3 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Note receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
3. Stated Rate More than Market Rate: A Premium

Had the note’s stated rate of 10% been greater than a market rate of 9%, the present value
would be greater than the face value of the note due to the premium. The same types of
calculations and entries as shown in the previous illustration regarding a discount would be
used. Note that the premium amortized each year would decrease the carrying amount of the
note at the end of each year until it reaches its face value amount of $10,000.
$10,000 Note Receivable Payment and Amortization Schedule

Stated rate of 10% and market rate of 9%
Received Income @9% Premium Amount
Date of issue $10,253
End of year 1 $1,000 $923* $77 10,176
End of year 2 1,000 916 84 10,091
End of year 3 1,000 908 92 10,000
End of year 3 final payment 10,000 - - 0
$13,000 $2,747 $253
* $10,253 × 9% = $923
Anchor’s entry on the note’s issuance date is for the present value amount (fair value):
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,253
If the company’s year-end was the same date as the note’s interest collected, at the end of
year 1 using the schedule above, the entry would be:
General Journal
End of year 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Note receivable (premium amortized 77
amount) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 923
For Interest income: (10,253 × 9%)
The entry when paid at maturity would be:
General Journal
End of year 3 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Note receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
4. Zero-Interest Bearing Notes
Some companies will issue zero-interest-bearing notes as a sales incentive. The notes do not
state an interest rate but the term “zero-interest” is inaccurate because financial instruments
always include an interest component that is equal to the difference between the cash lent
and the higher amount of cash repaid at maturity. Even though the interest rate is not stated,
the implied interest rate can be derived because the cash values lent and received are both
known. In most cases, the transaction between the issuer and acquirer of the note is at arm’s
length, so the implicit interest rate would be a reasonable estimate of the market rate.
Assume that on January 1, Eclipse Corp. received a five-year, $10,000 zero-interest bearing
note. The amount of cash lent to the issuer (which is equal to the present value) is $7,835
(rounded). Eclipse’s year-end is December 31. Looking at the cash flows and the time line:
N = years 0 1 2 3 4 5
$10,000
Present Value (PV) = ($7,835)
Interest
I/Y = (+/- 7835 PV, 0 PMT, 5 N, 10000 FV)

where I/Y is interest
PV is the amount of cash lent
N is # of periods
FV is the future cash received
Interest = 5% (rounded), or $2,165
Notice that the sign for the $7,835 PV is preceded by the +/- symbol, meaning that the
PV amount is to have the opposite symbol to the $10,000 FV amount, shown as a positive
value. This is because the FV is the cash received at maturity or cash inflow (positive value),
while the PV is the cash lent or a cash outflow (opposite or negative value). Many business
calculators require the use of a +/- sign for one value and no sign (or a positive value) for the
other to calculate imputed interest rates correctly. Consult your calculator manual for further
instructions regarding zero-interest note calculations.
The implied interest rate is calculated to be 5% and the note’s interest component (rounded)
is $2,165 ($10,000 − $7,835), which is the difference between the cash lent and the higher
amount of cash repaid at maturity. Below is the schedule for the interest and amortization
calculations using the effective interest method.
Non-Interest-Bearing Note Receivable Payment and Amortization Schedule

Received Income @5% Discount Amount
Date of issue $7,835.26
End of year 1 $0 $391.76* $391.76 8,227.02
End of year 2 0 411.35 411.35 8,638.37
End of year 3 0 431.92 431.92 9,070.29
End of year 4 0 453.51 453.51 9,523.81
End of year 5 0 476.19 476.19 10,000.00
End of year 5 payment 10,000 0
$2,164.74 $2,164.74
* $7,835.26 × 5% = $391.76
The entry for the note receivable when issued would be:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,835.26
At Eclipse’s year-end of December 31, the interest income at the end of the first year using the
effective interest method would be:
General Journal
Dec 31 Note receivable (discount amortized amount) . . 391.76
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 391.76
(7,835.26 × 5%)
At maturity when the cash interest is received, the entry would be:
General Journal
End of year 5 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Note receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
If Eclipse used ASPE instead of IFRS, the entry using straight-line method for amortizing the
discount is calculated as the total discount of $2,164.74, amortized over the five-year term of
the note resulting in equal amounts each year. Therefore, the annual amortization is $432.95
($2,164.74 ÷ 5 years) each year is recorded as:
General Journal
End of year 1 Note receivable (discount amortized amount) . . 432.95
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 432.95
5. Notes Receivable in Exchange for Property, Goods, or Services
When property, goods, or services are exchanged for a note, and the market rate and the
timing and amounts of cash received are all known, the present value of the note can be
determined. For example, assume that on May 1, Hudson Inc. receives a $200,000, five-year
note in exchange for land originally costing $120,000. The market rate for a note with similar
characteristics and risks is 8%. The present value is calculated as follows:
PV = (0 PMT, 8 I/Y, 5 N, 200000 FV)
PV = $136,117
The entry upon issuance of the note and sale of the land would be:
General Journal
May 1 Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136,117
Gain on sale of land. . . . . . . . . . . . . . . . . . . . . . . . 16,117
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000
However, if the market rate is not known, either of following two approaches can be used to
determine the fair value of the note:
a. Determine the fair value of the property, goods, or services given up. As was dis-
cussed for zero-interest bearing notes where the interest rate was not known, the implicit
interest rate can still be derived because the cash amount lent, and the timing and
amount of the cash flows received from the issuer are both known. In this case the
amount lent is the fair value of the property, goods, or services given up. Once the
interest is calculated, the effective interest method can be applied.1
For example, on June 1, Mayflower Consulting Ltd. receives a $40,000, three-year note
in exchange for some land. The market rate cannot be accurately determined due to
Source: http://www.iasplus.com/en/standards/ifrs/ifrs13 IFRS 13 Fair Value Measure-
1
ment applies to IFRSes that require or permit fair value measurements or disclosures and provides a single
IFRS framework for measuring fair value and requires disclosures about fair value measurement. The Standard
defines fair value on the basis of an “exit price” notion and uses a “fair value hierarchy,” which results in a market-
based, rather than entity-specific, measurement. IFRS 13 was originally issued in May 2011 and applies to
annual periods beginning on or after 1 January 2013 and is beyond the scope of this course. For simplicity, the
fair value of the property, goods or services given up as explained in the chapter material assumes that IFRS 13
assumptions and hierarchy to determine fair values have been appropriately considered.
credit risks regarding the issuer. The land cost and fair value is $31,750. The interest
rate is calculated as follows:
I/Y = (+/-31750 PV, 0 PMT, 3 N, 40000 FV)
I/Y = 8%; the interest income component is $8,250 over three years ($40,000 − $31,750)
The entry upon issuance of the note would be:
General Journal
Jun 1 Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31,750
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31,750
b. Determine an imputed interest rate. An imputed interest rate is an estimated interest

rate used for a note with comparable terms, conditions, and risks between an indepen-
dent borrower and lender.
On June 1, Edmunds Co. receives a $30,000, three-year note in exchange for some
swampland. The land has a historic cost of $5,000 but neither the market rate nor the
fair value of the land can be determined. In this case, a market rate must be imputed and
used to determine the note’s present value. The rate will be estimated based on interest
rates currently in effect for companies with similar characteristics and credit risk as the
company issuing the note. For IFRS companies, the “evaluation hierarchy” identified in
IFRS 13 Fair Value Measurement would be used to determine the fair value of the land
and the imputed interest rate. In this case, the imputed rate is determined to be 7%. The
present value is calculated as follows:
PV = (7 I/Y, 3 N, 30000 FV)
PV = $24,489
The entry upon issuance of the note would be:
General Journal
Jun 1 Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,489
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Loans to employees
In cases where there are non-interest-bearing long-term loans to company employees, the
fair value is determined by using the market rate for loans with similar characteristics, and the
present value is calculated on that basis. The amount loaned to the employee invariably will be
higher than the present value using the market rate because the loan is intended as a reward
or incentive. This difference would be deemed as additional compensation and recorded as
Compensation expense.
Impairment of notes receivable

Just as was the case with accounts receivable, there is a possibility that the holder of the
note receivable will not be able to collect some or all of the amounts owing. If this happens,
the receivable is considered impaired. When the investment in a note receivable becomes
impaired for any reason, the receivable is re-measured at the present value of the currently
expected cash flows at the loan’s original effective interest rate.
The impairment amount is recorded as a debit to bad debt expense and as a credit either to
an allowance for uncollectible notes account (a contra account to notes receivable) or directly
as a reduction to the asset account.
6.3.3 Derecognition and Sale of Receivables: Shortening the Credit-to-Cash

Cycle
Derecognition is the removal of a previously recognized receivable from the company’s bal-
ance sheet. In the normal course of business, receivables arise from credit sales and, once
paid, are removed (derecognized) from the books. However, this takes valuable time and
resources to turn receivables into cash. As someone once said, “turnover is vanity, profit is
sanity, but cash is king”2 . Simply put, a business can report all the profits possible, but profits
do not mean cash resources. Sound cash flow management has always been important but,
since the economic downturn in 2008, it has become the key to survival for many struggling
businesses. As a result, companies are always looking for ways to shorten the credit-to-cash
cycle to maximize their cash resources. Two such ways are secured borrowings and sales of
receivables, discussed next.
Secured Borrowings
Companies often use receivables as collateral for a loan or a bank line of credit. The receiv-
ables are pledged as security for the loan, but the control and collection often remain with
the company, so the receivables are left on the company’s books. The company records the
proceeds of the loan received from the finance company as a liability with the loan interest
and any other finance charges recorded as expenses. If a company defaults on its loan, the
finance company can seize the secured receivables and directly collect the cash from the
receivables as payment against the defaulted loan. This will be illustrated in the section on
factoring, below.
Sales of Receivables
What is the accounting treatment if a company’s receivables are transferred (sold) to a third
party (factor)? Certain industry sectors, such as auto dealerships and almost all small- and
medium-sized businesses selling high-cost goods (e.g., gym equipment retailers) make exten-
2
“Cash is king” is a catch phrase for “cash is most important.” While a firm can generate a profit, if it cannot
be converted to cash fast enough to pay the liabilities as they are due, then the company runs the risk of failing.
sive use of third-party financing arrangements with their customers to speed up the credit-to-
cash cycle. Whether a receivable is transferred to a factor (sale) or held as security for a loan
(borrowing) depends on the criteria set out in IFRS and ASPE which are discussed next.
Conditions for Treatment as a Sale
For accounting purposes, the receivables should be derecognized as a sale when they meet
the following criteria:
IFRS—substantially all of the risks and rewards have been transferred to the factor. The
evidence for this is that the contractual rights to receive the cash flows have been transferred
(or the company continues to collect and forward all the cash it collects without delay) to the
factor. As well, the company cannot sell or pledge any of these receivables to any third parties
other than to the factor.
ASPE—control of the receivables has been surrendered by the transferor. This is evidenced
when the following three conditions are all met:
a. The transferred assets have been isolated from the transferor.
b. The factor has obtained the right to pledge or to sell the transferred assets.
c. The transferor does not maintain effective control of the transferred assets through a
repurchase agreement.
If the conditions for either IFRS or ASPE are not met, the receivables remain in the accounts
and the transaction is treated as a secured borrowing (recorded as a liability) with the receiv-
ables as security for the loan. The accounting treatment regarding the sale of receivables
using either standard is a complex topic; the discussion in this section is intended as a basic
overview.
Below are some different examples of sales of receivables; such as factoring and securitiza-
tion.
Factoring
Factoring is when individual accounts receivable are sold or transferred to a recipient or factor,
usually a financial institution, in exchange for cash minus a fee called a discount. The seller
does not usually have any subsequent involvement with the receivable and the factor collects
directly from the customer. (Companies selling fitness equipment exclusively use this method
for all their credit sales to customers.)
The downside to this strategy is that factoring is expensive. Factors typically charge a 2% to
3% fee when they buy the right to collect payments from customers. A 2% discount for an
invoice due in thirty days is the equivalent of a substantial 25% a year, and 3% is over 36%
per year compared to the much lower interest rates charged by banks and finance companies.
Most companies are better off borrowing from their bank, if it is possible to do so.
However, factors will often advance funds when more traditional banks will not. Even with only
a prospective order in hand from a customer, a business can turn to a factor to see if it will
assume or share the risk of the receivable. Without the factoring arrangement, the business
must take time to secure and collect the receivable; the factor offers a reduction in additional
effort and aggravation that may be worth the price of the fee paid to the factor.
There are risks associated with factoring receivables. Companies that intend to sell their
receivables to a factor need to check out the bank and customer references of any factor.
There have been cases where a factor has gone out of business, still owing the company
substantial amounts of money held back in reserve from receivables already paid up.
Factoring versus Borrowing: A Comparison
The difference between factoring and borrowing can be significant for a company that wants
to sell some or all of its receivables. Consider the following example:
Assume that on June 1, Cromwell Co. has $100,000 accounts receivable it wants to sell to
a factor that charges 10% as a financing fee. Below is the transaction recorded as a sale
of receivables compared to a secured note payable arrangement, starting with some opening
balances:
Cromwell Co. Balance Sheet – Opening Balances

Cash $ 10,000
Property, plant, and equipment 200,000
Total assets $360,000

Note payable 0
Equity 290,000
Total liabilities and equity $360,000
Debt-to-total assets ratio 19%
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000
Loss on sale of receivables . . . . . . . . . . . . . . . . . . . . 10,000
Cromwell Co. – Sale of Receivables. Loss on
sale: ($100,000 × 10%)
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000
Discount on note payable** . . . . . . . . . . . . . . . . . . . . 10,000
Note payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Cromwell Co. – Note Payable. **Discount
shown separately from notes payable for com-
parability. Discount will be amortized to interest
expense over the term of the note.
Below is the balance sheet after the transaction:

Cromwell Co. Balance Sheet – Sale of Receivables
Cash $100,000

Note payable 0
Equity 280,000
Cromwell Co. Balance Sheet – Note Payable

Cash $100,000

Note payable 90,000
Equity 290,000
Note that the entry for a sale is straightforward with the receivables of $100,000 derecognized
from the accounts and a decrease in retained earnings due to the loss reported in net income.
However, for a secured borrowing, a note payable of $90,000 is added to the accounts as
a liability, and the accounts receivable of $100,000 remains in the accounts as security for
the note payable. Referring to the journal entry above, in both cases cash flow increased by
$90,000, but for the secured borrowing, there is added debt of $90,000, affecting Cromwell’s
debt ratio and negatively impacting any restrictive covenants Cromwell might have with other
creditors. After the transaction, the debt-to-total assets ratio for Cromwell is 20% if the ac-
counts receivable transaction meets the criteria for a sale. The debt ratio worsens to 36% if
the transaction does not meet the criteria for a sale and is treated as a secured borrowing.
This impact could motivate managers to choose a sale for their receivables to shorten the
credit-to-cash cycle, rather than the borrowing alternative.
Sales without Recourse
For sales without recourse, all the risks and rewards (IFRS) as well as the control (ASPE) have
been transferred to the factor, and the company no longer has any involvement.
For example, assume that on August 1, Ashton Industries Ltd. factors $200,000 of accounts
receivable with Savoy Trust Co., the factor, on a without-recourse basis. All the risks, rewards,
and control are transferred to the finance company, which charges an 8% fee and withholds
a further 4% of the accounts receivables for estimated returns and allowances. The entry for
Ashton is:
General Journal
Aug 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176,000
Due from factor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000
For Due from factor: ($200,000 × 4%), for Loss
on sale of receivables: ($200,000 × 8%)
The accounting treatment will be the same for IFRS and ASPE since both sets of conditions
(risks and rewards and control) have been met. If no returns and allowances are given to
customers owing the receivables, Ashton will recoup the $8,000 from the factor. In turn,
Savoy’s net income will be the $16,000 revenue reduced by any uncollectible receivables,
since it now has assumed the risks/rewards and control of these receivables.
Sales with Recourse
In this case, Ashton guarantees payment to Savoy for any uncollectible receivables (recourse
obligation). Under IFRS, the guarantee means that the risks and rewards have not been
transferred to the factor, and the accounting treatment would be as a secured borrowing as
illustrated above in Cromwell—Note Payable. Under ASPE, if all three conditions for treatment
as a sale as described previously are met, the transaction can be treated as a sale.
Continuing with the example for Ashton, assume that the receivables are sold with recourse,
the company uses ASPE, and that all three conditions have been met. In addition to the 8%
fee and 4% withholding allowance, Savoy estimates that the recourse obligation has a fair
value of $5,000. The entry for Ashton, including the estimated recourse obligation is:
General Journal
Aug 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176,000
Due from factor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000
Recourse liability. . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
For Due from factor: ($200,000 × 4%), for Loss
on sale of receivables: ($16,000 + $5,000)
You will see that the recourse liability to Savoy results in an increase in the loss on sale of re-
ceivables by the recourse liability amount of $5,000. If there were no uncollectible receivables,
Ashton will eliminate the recourse liability amount and decrease the loss. Savoy’s net income
will be the finance fee of $16,000 with no reductions in revenue due to uncollectible accounts,
since these are being guaranteed and assumed by Ashton.
Securitization
Securitization is a financing transaction that gives companies an alternative way to raise funds
other than by issuing debt, such as a corporate bond or note. The process is extremely
complex and the description below is a simplified version.
The receivables are sold to a holding company called a Special Purpose Entity (SPE), which is
sponsored by a financial intermediary. This is similar to factoring without recourse, but is done
on a much larger scale. This sale of receivables and their removal from the accounting records
by the company holding the receivables is an example of off-balance sheet accounting. In its
most basic form, the securitization process involves two steps:
Step 1: A company (the asset originator) with receivables (e.g., auto loans, credit card debt),
identifies the receivables (assets) it wants to sell and remove from its balance sheet. The
company divides these into bundles, called tranches, each containing a group of receivables
with similar credit risks. Some bundles will contain the lowest risk receivables (senior tranches)
while other bundles will have the highest risk receivables (junior tranches).
The company sells this portfolio of receivable bundles to a special purpose entity (SPE) that
was created by a financial intermediary specifically to purchase these types of portfolio assets.
Once purchased, the originating company (seller) derecognizes the receivables and the SPE
accounts for the portfolio assets in its own accounting records. In many cases, the company
that originally sold the portfolio of receivables to the SPE continues to service the receivables
in the portfolio, collects payments from the original borrowers and passes them on—less
a servicing fee—directly to the SPE. In other cases, the originating company is no longer
involved and the SPE engages a bank or financial intermediary to collect the receivables as a
collecting agent.
Step 2: The SPE (issuing agent) finances the purchase of the receivables portfolio from
the originating company by issuing tradeable interest-bearing securities that are secured or
backed by the receivables portfolio it now holds in its own accounting records as stated in Step
1—hence the name asset-backed securities (ABS). These interest-bearing ABS securities
are sold to capital market investors who receive fixed or floating rate payments from the SPE,
funded by the cash flows generated by the portfolio collections. To summarize, securitization
represents an alternative and diversified source of financing based on the transfer of credit risk
(and possibly also interest rate and currency risk) from the originating company and ultimately
to the capital market investors.
The Downside of Securitization
Securitization is inherently complex, yet it has grown exponentially. The resulting highly com-
petitive securitization markets with multiple securitizers (financial institutions and SPEs), in-
crease the risk that underwriting standards for the asset-backed securities could decline and
cause sharp drops in the bundled or tranched securities’ market values. This is because both
the investment return (principal and interest repayment) and losses are allocated among the
various bundles according to their level of risk. The least risky bundles, for example, have first
call on the income generated by the underlying receivables assets, while the riskiest bundles
have last claim on that income, but receive the highest return.
Typically, investors with securities linked to the lowest-risk bundles would have little expectation
of portfolio losses. However, because investors often finance their investment purchase by
borrowing, they are very sensitive to changes in underlying receivables assets’ quality. This
sensitivity was the initial source of the problems experienced in the sub-prime mortgage
market (derivatives) meltdown in 2008. At that time, repayment issues surfaced in the riskiest
bundles due to the weakened underwriting standards, and lack of confidence spread to in-
vestors holding even the lowest risk bundles, which caused panic among investors and a flight
into safer assets, resulting in a fire sale of securitized debt of the SPEs.
In the future, securitized products are likely to become simpler. After years of posting virtually
no capital reserves against high-risk securitized debt, SPEs will soon be faced with regulatory
changes that will require higher capital charges and more comprehensive valuations. Reviving
securitization transactions and restoring investor confidence might also require SPEs to retain
an interest in the performance of securitized assets at each level of risk (Jobst, 2008).
6.3.4 Disclosures of Receivables
The standards for receivables reporting and disclosures have been in a constant state of
change. IFRS 7 (IFRS, 2015) and IAS 1 (IAS, 2003) include significant disclosure require-
ments that provide information based on significance and the nature and extent of risks.
The Significance of Financial Instruments
IFRS 7 and IAS 1 specify the separate reporting categories based on significance such as the
following:
• Trade accounts, amounts owing from related parties, prepayments, tax refunds, and
other significant amounts
• Current amounts from non-current amounts
• Any impaired balances and amount of any allowance for credit risk and a reconciliation
of the changes in the allowance account during the accounting period
• Disclosure on the income statement of the amounts of interest income, impairment

losses, and any reversals associated with impairment losses
• Net losses on sales of receivables (IFRS, 2015, 7.20 a, iv).
For each receivables category above, the following disclosures are required:
• The carrying amounts such as amortized cost/cost and fair values (including methods
used to estimate fair value) with details of any amounts reclassified from one category
to another or changes in fair values
• Carrying amount and terms and conditions regarding financial assets pledged as collat-
eral or any financial assets held as collateral
• An indication of the amounts and, where practicable, the maturity dates of accounts with
a maturity of more than one year
• For IFRS, extensive disclosures of major terms regarding the securitization or transfers
of receivables, whether these have been derecognized in their entirety or not. Some
of these disclosures include the characteristics of the securitization, the fair value mea-
surements and methods used and cash flows, as well as the nature of the servicing
requirements and associated risks.
The Nature and Extent of Risks Arising from Financial Instruments
Stakeholders, such as investors and creditors, want to know about the various transactions
that hold risks. Basic types of risks and related disclosures are:
• Credit risk—the risk that one party to a financial instrument will default on its debt
obligation. Disclosures include an analysis of the age of financial assets that are past
6.4. Cash and Receivables: Analysis 217
due as at the end of the reporting period but not impaired and an analysis of financial
assets that are individually determined to be impaired as at the end of the reporting
period, including the factors the entity considered in determining that they are impaired
(IFRS 2015, 7.37 a, b).
• Liquidity risk—the risk that an entity will have difficulties in paying its financial liabilities.
• Market risk—the risk that the fair value or cash flows of a receivable will fluctuate due
to changes in market prices which are affected by interest rate risk, currency risk, and
other price risks. Disclosures include a sensitivity analysis for each type of market risk
to which the entity is exposed at the end of the reporting period, showing how profit or
loss and equity would have been affected by changes in the relevant risk variable that
were reasonably possible at that date (IFRS 2015, 7.40 a).
In addition, information about company policies for managing risk, including quantitative and
qualitative data, is to be disclosed. ASPE disclosure requirements are much the same as
IFRS, though perhaps requiring slightly less information about risk exposures and fair values
than IFRS (CPA Canada, 2016, Part II, Section 3856.38–42).
6.4 Cash and Receivables: Analysis
The most common analytical tool regarding cash is the statement of cash flows. This state-
ment reveals how a company spends its money (cash outflows) and where the money comes
from (cash inflows). It is well known that a company’s profitability, as shown by its net income,
is an important performance evaluator. Although accrual accounting provides a basis for
matching revenues and expenses, this system does not actually reflect the amount of cash
that the company has received from its profits. This can be a crucial distinction as discussed
earlier in this chapter. The statement of cash flows was discussed in Chapter 4.
For receivables analysis, three key financial tools are:
• An accounts receivable aging report
• Trendline analysis
• Ratio analysis
Accounts Receivable Aging Report
One of the easiest methods for analyzing the state of a company’s accounts receivable is
to print an accounts receivable aging report, which is a standard report available in any
accounting software package. As was discussed earlier in this chapter, this report divides the
age of the accounts receivable into various groups according to the amount of time uncollected.
Any invoices uncollected for greater than 30 days are cause for increased vigilance, especially
if they drop into the oldest time grouping.
There are several issues to be aware of when analyzing accounts receivables based on an
aging report.
Individual credit terms—Management may have authorized unusually long credit terms to
specific customers, or for specific types of invoices. If so, these items may appear to be
severely overdue for payment when they are, in fact, not yet due for payment at all.
Distance from billing date—In many companies, most of the invoices are billed at the end
of the month. If an aging report is run a few days later as part of the month-end analysis, it
will likely still show outstanding accounts receivable from one month ago for which payment is
about to arrive, as well as the full amount of all the receivables that were just billed a few days
ago. In total, it appears that receivables are in a bad state. However, if you were to run the
report just prior to the month-end billing activities, there would be far fewer accounts receivable
in the report, and there may appear to be very little cash coming from uncollected receivables.
Time grouping size—The groupings should approximate the duration regarding the company’s
credit terms. For example, if credit terms are just ten days and the first time grouping spans
30 days, nearly all invoices will appear to be current.
Trendline Analysis
Another accounts receivable analysis tool is the trendline. If the outstanding accounts receiv-
able balance at the end of each month for the past year is graphed, it can be used to predict
the amount of receivables that should be outstanding in the near future. This is a particularly
valuable tool when sales are seasonal, since you can apply seasonal variability to estimates
of future sales levels.
Trendline analysis is also useful for comparing the percentage of bad debts to sales over
time. If there is a strong recurring trend in this percentage, management will likely take
action. As was discussed earlier, if the percentage of bad debt is increasing, management
will likely authorize tighter credit terms to customers. Conversely, if the bad debt percentage
is extremely low, management may elect to loosen credit terms to expand sales to somewhat
more risky customers. Their philosophy will be that not all customers in the riskier categories
will default on paying their debts to suppliers so there should be a net benefit from increasing
sales. The bottom line is that the credit terms need to strike a balance between the two
opposites. Trendline analysis is a particularly useful tool when you run the bad debt percentage
analysis for individual customers, since it can spotlight problems that may indicate the possible
bankruptcy of a customer.
There are two issues to be aware of when you use trendline analysis:
• Change in credit policy. If management has authorized a change in the credit policy, it
can lead to sudden changes in accounts receivable or bad debt levels.
• Change in products or business lines. If a company adds to or deletes from its mix
of products or business lines, it may cause profound changes in the trend of accounts
receivable.
An interesting analysis related to accounts receivable is a trendline of the proportion of cus-

tomer sales that are paid at the time of sale, noting the payment type used. Changes in
a company’s selling procedures and policies may shift sales toward or away from up-front
payments, which therefore has an impact on the amount and characteristics of accounts
receivable.
Ratio Analysis
A third type of accounts receivable analysis is ratio analysis. Ratios, on their own, do not really
tell the whole story. Ratios compared to a benchmark, such as an industry sector or previous
period trends will be more meaningful. Some of the more common ratios that include cash
and accounts receivable are:
• Quick or acid-test ratio, which measures immediate debt-paying ability
• Accounts receivable turnover, which measures how quickly the receivables are con-
verted into cash
• Days’ sales uncollected, which measures the number of days that receivables remain
uncollected
These are examples of liquidity ratios which measure a company’s ability to pay its debts as
they come due. Below is selected financial data for Best Coffee and Donuts:
Best Coffee and Donuts Inc.

Excerpts from the Consolidated Balance sheet
(in thousands of Canadian dollars)
(Unaudited)
As at
December 29, December 30,
2021 2020
Current assets
Cash and cash equivalents $ 50,414 $ 120,139
Restricted cash and cash equivalents 155,006 150,574
Accounts receivable, net (includes royalties
and franchise fees receivable) 210,664 171,605
Notes receivable, net 4,631 7,531
Deferred income taxes 10,165 7,142
Inventories and other, net 104,326 107,000
Advertising fund restricted assets 39,783 45,337
Total current assets $ 574,989 $ 609,328
Current liabilities
Accrued liabilities 274,008 227,739
Deferred income taxes - 197

Advertising fund liabilities 59,912 44,893
Short-term borrowings 30,000 -

Current portion of long-term obligations 17,782 20,781
Total current liabilities $ 586,216 $ 463,372
Best Coffee and Donuts Inc.

Excerpts from the Consolidated Statement of Operations
(in thousands of Canadian dollars, except share and per share data)
(Unaudited)
Year ended
December 29, December 30,
2021 2020
REVENUES
Sales $ 2,265,884 $ 2,225,659
Franchise revenues
Rents and royalties 821,221 780,992
Franchise fees 168,428 113,853
989,649 894,845
TOTAL REVENUES $ 3,255,533 $ 3,120,504
Quick ratio
The quick or acid-test ratio, measures only the most liquid current assets available to cover its
current liabilities. The quick ratio is more conservative than the current ratio which includes
all current assets and current liabilities because it excludes inventory and any other current
assets that are not highly liquid.
Formula:
Cash & cash equivalents + short-term investments + current receivables

Quick Ratio =
Current liabilities
Calculation:
2021 2020
$50,414+$210,664+$4,631 $120,139+$171,605+$7,531
Quick Ratio = $586,216
= .45 $463,372
= .65
As of December 31, 2021, with amounts expressed in thousands, Best Coffee and Donuts’
quick current assets amounted to $265,709, while current liabilities amounted to $586,216.
The resulting ratio produced is .45. This means that there is $.45 of the most liquid current
assets available for each $1.00 of current liabilities. If a quick ratio of greater than $1.00 is a
reasonable measure of liquidity, this means that Best Coffee and Donuts’ ability to cover its
current liabilities as they mature is at risk. Moreover, this ratio has weakened compared to the
previous year of .65 or $.65 for each $1.00 in current liabilities.
Variations
In practice, some presentations of the quick ratio calculate quick assets (the formula’s numer-
ator) as simply the total current assets minus the inventory account. This is quicker and easier
to calculate. By excluding a relatively less-liquid account such as inventory, it is thought that
the remaining current assets will be of the more-liquid variety.
Using Best Coffee and Donuts as an example, for 2021, the quick ratio using the shorter
calculation would be:
$574,989 − $104,326
Quick ratio = = .80
$586,216
It is clear from the comparative calculations that .80 is significantly higher than the previously
calculated .45 ratio. Restricted cash, prepaid expenses, and deferred income taxes do not
pass the test of truly liquid assets. Thus, using the shorter calculation artificially overstates
Best Coffee and Donuts more-liquid current assets and inflates its quick ratio. For this reason,
it is not advisable to rely on this abbreviated version of the quick ratio.
Another type of analysis is to compare the quick ratio with its corresponding current ratio. If the
current ratio is significantly higher, it is a clear indication that the company’s current assets are
dependent on inventory and other “less than liquid” current assets, such as legally restricted
cash balances.
Even though the quick ratio is a more conservative measure of liquidity than the current ratio,
they both share the same problems regarding the time it takes to convert accounts receivables
to cash in that they assume a liquidation of accounts receivable as the basis for measuring
liquidity. In truth, a company must focus on the time it takes to convert its working capital assets
to cash—that is the true measure of liquidity. This is the credit-to-cash cycle emphasized
throughout this chapter. So, if a company’s accounts receivable, has a much longer conversion
time than a typical credit policy of thirty days, the quickness attribute of this ratio becomes a
focal point. For this reason, investors and creditors need to be aware that relying solely on
the current and quick ratios as indicators of a company’s liquidity can be misleading. The
“quickness” attribute will be discussed next.
Accounts Receivable Turnover Ratio
The accounts receivable turnover ratio measures the number of times per year on average
that it takes to collect a company’s receivables. When using this ratio for analysis, the following
issues must be considered:
• Credit sales, rather than all sales, would be the better measure to use for the numerator,
but this information can be more difficult to obtain by third parties such as prospective
investors and creditors, so total sales are often used in practice.
• Typically, average receivables outstanding are usually calculated from the beginning and
ending balances. However, if a business has significant seasonal cycles, calculating a
series of turnover averages throughout the fiscal year, such as semi-annually or quar-
terly, will likely provide better results.
• Companies can choose to sell their receivables making comparability with other compa-
nies not suitable.
• Net accounts receivable includes the allowance for doubtful accounts (AFDA), so the
choice of what method and rates to use when estimating uncollectible accounts can vary
significantly between companies, resulting in invalid comparisons.
The key consideration is to ensure comparability and consistency when interpreting ratio
analysis, since ratios are used to determine favourable or unfavourable trends resulting from
comparison to other factors. Using Best Coffee and Donuts data, we calculate the following:
Formula:
Net credit sales (or net sales, if unavailable)

A/R turnover =
Average net accounts receivable
Calculation for 2021:
$3,255,533
A/R turnover =
($210,664 + 171,605) ÷ 2
= 17.03 times or every 21.43 days on average (365/17.03 = 21.43)
If the industry standard or the company credit policy is n/30 days, an accounts receivable
turnover of every twenty-one days on average would be a favourable outcome compared to
the thirty-day due date set by the company’s credit policy. Aging schedules would provide
further information about the quality of specific receivables and would highlight any customer
accounts that were overdue and requiring immediate attention.
Days’ sales uncollected
This ratio estimates how many days it takes to collect on the current receivables outstanding.
Formula:

Accounts receivable (net)
Days’ sales uncollected = × 365
Net sales
Calculation for 2021:

$210,664
Days’ sales uncollected = × 365 = 23.62 days
$3,255,533
Note that the average receivables are not used in this calculation. This means that the
ratio measures the collectability of the current accounts receivables instead of the average
accounts receivable. If a guideline for this ratio is that it should not exceed 1.33 times its credit
period when no discount is offered (or the discount period if a discount is offered), 23.62 days
compared to the benchmark of forty days (30 days × 1.33) means that the ratio is favourable.
The best way to analyze accounts receivable is to use all three techniques. The accounts
receivable collection period can be used to get a general idea of the ability of a company to
collect its accounts receivable, add an analysis of the aging report to determine exactly which
invoices are causing collection problems, and add trend analysis to see if these problems have
been changing over time.
Item ASPE IFRS

Cash equivalents Equity investments are ex- Preferred shares can be in-
cluded from this classifica- cluded if there is a specified
tion. redemption date and are ac-
quired close to their maturity
date.
Accounts Initially measured at net Same as ASPE
receivable—initial realizable value (net of
measurement trade discounts and sales
discounts, returns and
allowances) in lieu of fair
value given their short-term
nature (there is no significant
interest component).
Accounts Cost in lieu of amortized cost Same as ASPE
receivable—subsequent since there is no significant
measurement interest component.
Accounts Impairment is determined by Same as ASPE
receivable—impairment estimating uncollectible ac-
counts using either accounts
receivable or credit sales as
the basis. Direct write-off
of uncollectible accounts di-
rectly to bad debt expense
is only used under limited
circumstances.
Short-term notes In lieu of fair value, mea- Same as ASPE
receivable—initial and sured at NRV:
subsequent measurement
face value plus stated
rate of interest for interest-
bearing notes and face
value which includes
interest for non-interest-
bearing notes.
Long-term notes At fair value: Same as ASPE
receivable—initial Interest bearing: Present
measurement value of the expected cash
flows discounted at the mar-
ket rate of interest.
6.5. IFRS/ASPE Key Differences 225
Non-interest bearing:
Present value of the
expected cash flows
discounted at the market
rate of interest. The interest
component is the difference
between the proceeds (the
present value set by the
lender) and the repayment
amount.
Long-term notes Measured at amortized cost Measured at amortized cost
receivable—subsequent using either the straight-line using the effective interest
measurement method or the effective in- rate method for interest, dis-
terest method for interest, counts, or premiums.
discounts, or premiums.
Long-term notes If impaired, the receivable is If impaired, the receivable is
receivable—impairment re-measured at the present remeasured at the present
value of the expected cash value of the expected cash
flows at the current market flows at the loan’s original
interest rate. effective interest rate.
Long-term notes Capitalized at acquisition Same as ASPE
receivable—transaction and added to discount or
costs premium to be amortized
over life of note.
Derecognition of When the entity has given When substantially all of
receivables up the control of the receiv- the risks and rewards have
ables by meeting all three been transferred:
conditions:
• The contractual rights to
• The transferred assets are receive the cash flows
isolated in the books. is transferred or collected
and immediately passed
• The company does not on to the recipient.
have a repurchase agree-
ment. • The company cannot sell
or pledge any of these re-
• The receiver (factor) has ceivables to any third par-
the right to pledge or sell ties other than to the factor.
the assets.
Derecognition of If all three conditions met, If condition met, treat as a

receivables—sale without treat as a sale, otherwise as sale, otherwise as a secured
recourse a secured borrowing. borrowing.
Derecognition of If all three conditions met, Treat as a secured borrow-
receivables—sale with treat as a sale, otherwise as ing.
recourse a secured borrowing.
Disclosure of receivables Are to provide information Are to provide information

about: about:
• the significance of finan- • the significance of finan-

cial instruments cial instruments
• the nature and extent of • the nature and extent of

risks arising from financial risks arising from financial
instruments instruments
Less disclosure More information required

requirements than IFRS. than ASPE, including
a reconciliation of any
changes in the allowance
account and extensive
disclosures regarding
securitization transactions.
Analysis of receivables Three financial tools: Same as ASPE
• An accounts receivable ag-

ing report
• Trendline analysis
• Ratio analysis
6.6 Appendix A: Review of Internal Controls, Petty Cash, and Bank

Reconciliations
Internal Control
Assets are the lifeblood of a company and must be protected. This duty falls to managers
of a company. The policies and procedures implemented by management to protect assets
are collectively referred to as internal controls. An effective internal control program not
only protects assets, but also aids in accurate record-keeping, produces financial statement
information in a timely manner, ensures compliance with laws and regulations, and promotes
efficient operations. Effective internal control procedures ensure that adequate records are
maintained, transactions are authorized, duties among employees are divided between record-
keeping functions and control of assets, and employees’ work is checked by others. The use
of electronic recordkeeping systems does not decrease the need for good internal controls.
The effectiveness of internal controls is limited by human error and fraud. Human error can
6.6. Appendix A: Review of Internal Controls, Petty Cash, and Bank Reconciliations 227
occur because of negligence or mistakes. Fraud is the intentional decision to circumvent

internal control systems for personal gain. Sometimes, employees cooperate with each other
to avoid internal controls. This collusion is often difficult to detect, but fortunately, it is not a
common occurrence when adequate controls are in place.
Internal controls take many forms. Some are broadly based, like mandatory employee drug
testing, video surveillance, and scrutiny of company email systems. Others are specific to
an asset type or process. For instance, internal controls need to be applied to a company’s
accounting system to ensure that transactions are processed efficiently and correctly to pro-
duce reliable records in a timely manner. Procedures should be documented to promote
good recordkeeping, and employees need to be trained in the application of internal control
procedures.
Financial statements prepared according to generally accepted accounting principles are use-
ful not only to external users in evaluating the financial performance and financial position of
the company, but also for internal decision making. There are various internal control mecha-
nisms that aid in the production of timely and useful financial information. For instance, using a
chart of accounts is necessary to ensure transactions are recorded in the appropriate account.
As an example, expenses are classified and recorded in applicable expense accounts, then
summarized and evaluated against those of a prior year.
The design of accounting records and documents is another important means to provide
financial information. Financial data is entered and summarized in records and transmitted
by documents. A good system of internal control requires that these records and documents
be prepared at the time a transaction takes place or as soon as possible afterwards, since
they become less credible and the possibility of error increases with the passage of time.
The documents should also be consecutively pre-numbered, to indicate whether there may be
missing documents.
Internal control also promotes the protection of assets. Cash is particularly vulnerable to
misuse. A good system of internal control for cash should provide adequate procedures for
protecting cash receipts and cash payments (commonly referred to as cash disbursements).
Procedures to achieve control over cash vary from company to company and depend upon
such variables as company size, number of employees, and cash sources. However, effective
cash control generally requires the following:
• Separation of duties: People responsible for handling cash should not be responsible for
maintaining cash records. By separating the custodial and record-keeping duties, theft
of cash is less likely.
• Same-day deposits: All cash receipts should be deposited daily in the company’s bank
account. This prevents theft and personal use of the money before deposit.
• Payments made using non-cash means: Cheques or electronic funds transfer (EFT)
provide a separate external record to verify cash disbursements. For example, many
businesses pay their employees using electronic funds transfer because it is more secure
and efficient than using cash or even cheques.
Two forms of internal control over cash will be discussed in this chapter: the use of a petty
cash account and the preparation of bank reconciliations.
Petty Cash
The payment of small amounts by cheque may be inconvenient and costly. For example, using
cash to pay for postage on an incoming package might be less than the total processing cost
of a cheque. A small amount of cash kept on hand to pay for small, infrequent expenses is
referred to as a petty cash fund.
Establishing and Reimbursing the Petty Cash Fund
To set up the petty cash fund, a cheque is issued for the amount needed. The custodian of the
fund cashes the cheque and places the coins and currency in a locked box. Responsibility for
the petty cash fund should be delegated to only one person, who should be held accountable
for its contents. Cash payments are made by this petty cash custodian out of the fund as
required when supported by receipts. When the amount of cash has been reduced to a pre-
determined level, the receipts are compiled and submitted for entry into the accounting system.
A cheque is issued to reimburse the petty cash fund. At any given time, the petty cash amount
should consist of cash and supporting receipts, that total to the petty cash fund amount. To
demonstrate the management of a petty cash fund, assume that a $200 cheque is issued to
establish a petty cash fund.
The journal entry is:
General Journal
Petty Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
To establish the $200 petty cash fund.
Petty Cash is a current asset account and is reported with Cash as one amount.
Assume the petty cash custodian has receipts totalling $190 and $10 in coin and currency
remaining in the petty cash box. The receipts consist of the following: delivery charges $100,
$35 for postage, and office supplies of $55. The petty cash custodian submits the receipts to
the accountant who records the following entry and issues a cheque for $190.
General Journal
Delivery Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Postage Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Office Supplies Expense3 . . . . . . . . . . . . . . . . . . . . . 55
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190
To reimburse the petty cash fund.
The petty cash receipts should be cancelled at the time of reimbursement to prevent their
reuse for duplicate reimbursements. The petty cash custodian cashes the $190 cheque. The
$190 plus the $10 of coin and currency in the locked box immediately prior to reimbursement
equals the $200 total required in the petty cash fund.
Sometimes, the receipts plus the coin and currency in the petty cash locked box do not equal
the required petty cash balance. To demonstrate, assume the same information above except
that the coin and currency remaining in the petty cash locked box was $8. This amount plus
the receipts for $190 equals $198 and not $200, indicating a shortage in the petty cash box.
The entry at the time of reimbursement reflects the shortage and is recorded as:
General Journal
Postage Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Office Supplies Expense . . . . . . . . . . . . . . . . . . . . . . 55
Cash Over/Short Expense . . . . . . . . . . . . . . . . . . . . . 2
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 192
To reimburse the petty cash fund and account
for the $2.00 shortage.
The $192 credit to Cash plus the $8 of coin and currency remaining in the petty cash box
immediately prior to reimbursement equals the $200 required total in the petty cash fund.
Assume, instead, that the coin and currency in the petty cash locked box was $14. This amount
plus the receipts for $190 equals $204 and not $200, indicating an overage in the petty cash
box. The entry at the time of reimbursement reflects the overage and is recorded as:
General Journal
Postage Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
Office Supplies Expense . . . . . . . . . . . . . . . . . . . . . . 55
Cash Over/Short Expense . . . . . . . . . . . . . . . . . 4
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
To reimburse the petty cash fund and account
for the $4.00 overage.
3
An expense is debited instead of Office Supplies, an asset, because the need to purchase supplies through
petty cash assumes the immediate use of the items.
immediately prior to reimbursement equals the $200 required total in the petty cash fund.
What happens if the petty cash custodian finds that the fund is rarely used? In such a case,
the size of the fund should be decreased to reduce the risk of theft. To demonstrate, assume
the petty cash custodian has receipts totalling $110 and $90 in coin and currency remaining
in the petty cash box. The receipts consist of the following: delivery charges $80 and postage
$30. The petty cash custodian submits the receipts to the accountant and requests that the
petty cash fund be reduced by $75. The following entry is recorded and a cheque for $35 is
issued.
General Journal
Postage Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Petty Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
To reimburse the petty cash fund and reduce it
by $75.
immediately prior to reimbursement equals the $125 new balance in the petty cash fund ($200
original balance less the $75 reduction).
In cases when the size of the petty cash fund is too small, the petty cash custodian could
request an increase in the size of the petty cash fund at the time of reimbursement. Care
should be taken to ensure that the size of the petty cash fund is not so large as to become
a potential theft issue. Additionally, if a petty cash fund is too large, it may be an indicator
that transactions that should be paid by cheque are not being processed in accordance with
company policy. Remember that the purpose of the petty cash fund is to pay for infrequent
expenses; day-to-day items should not go through petty cash.
Cash Collections and Payments
The widespread use of banks facilitates cash transactions between entities and provides a
safeguard for the cash assets being exchanged. This involvement of banks as intermediaries
between entities has accounting implications. At any point in time, the cash balance in the
accounting records of a company usually differs from the bank cash balance. The difference
is usually because some cash transactions recorded in the accounting records have not yet
been recorded by the bank and, conversely, some cash transactions recorded by the bank
have not yet been recorded in the company’s accounting records.
The use of a bank reconciliation is one method of internal control over cash. The reconciliation
process brings into agreement the company’s accounting records for cash and the bank state-
ment issued by the company’s bank. A bank reconciliation explains the difference between
the balances reported by the company and by the bank on a given date.
A bank reconciliation proves the accuracy of both the company’s and the bank’s records, and
reveals any errors made by either party. The bank reconciliation is a tool that can help detect
attempts at theft and manipulation of records. The preparation of a bank reconciliation is
discussed in the following section.
The Bank Reconciliation Process
The bank reconciliation is a report prepared by a company at a point in time. It identifies

discrepancies between the cash balance reported on the bank statement and the cash balance
reported in a business’s Cash account in the general ledger, more commonly referred to as
the books. These discrepancies are known as reconciling items and are added or subtracted
to either the book balance or bank balance of cash. Each of the reconciling items is added or
subtracted to the business’s cash balance. The business’s cash balance will change as a result
of the reconciling items. The cash balance prior to reconciliation is called the unreconciled
cash balance. The balance after adding and subtracting the reconciling items is called the
reconciled cash balance. The following is a list of potential reconciling items and their impact
on the bank reconciliation.
Book reconciling items Bank reconciling items

Collection of notes receivable (added) Outstanding deposits (added)
NSF cheques (subtracted) Outstanding cheques (subtracted)
Bank charges (subtracted)
Book errors (added or subtracted, Bank errors (added or subtracted,
depending on the nature of the error depending on the nature of the error)
Book Reconciling Items
The collection of notes receivable may be made by a bank on behalf of the company. These
collections are often unknown to the company until they appear as an addition on the bank
statement, and so cause the general ledger cash account to be understated. As a result, the
collection of a notes receivable is added to the unreconciled book balance of cash on the bank
reconciliation.
Cheques returned to the bank because there were not sufficient funds (NSF) to cover them
appear on the bank statement as a reduction of cash. The company must then request that
the customer pay the amount again. As a result, the general ledger cash account is overstated
by the amount of the NSF cheque. NSF cheques must therefore be subtracted from the
unreconciled book balance of cash on the bank reconciliation to reconcile cash.
Cheques received by a company and deposited into its bank account may be returned by the
customer’s bank for many reasons (e.g., the cheque was issued too long ago, known as a
stale-dated cheque, an unsigned or illegible cheque, or the cheque shows the wrong account
number). Returned cheques cause the general ledger cash account to be overstated. These
cheques are therefore subtracted on the bank statement, and must be deducted from the
unreconciled book balance of cash on the bank reconciliation.
Bank service charges are deducted from the customer’s bank account. Since the service
charges have not yet been recorded by the company, the general ledger cash account is
overstated. Therefore, service charges are subtracted from the unreconciled book balance of
cash on the bank reconciliation.
A business may incorrectly record journal entries involving cash. For instance, a deposit or
cheque may be recorded for the wrong amount in the company records. These errors are
often detected when amounts recorded by the company are compared to the bank statement.
Depending on the nature of the error, it will be either added to or subtracted from the unrecon-
ciled book balance of cash on the bank reconciliation. For example, if the company recorded
a cheque as $520 when the correct amount of the cheque was $250, the $270 difference
would be added to the unreconciled book balance of cash on the bank reconciliation. Why?
Because the cash balance reported on the books is understated by $270 because of the error.
As another example, if the company recorded a deposit as $520 when the correct amount of
the deposit was $250, the $270 difference would be subtracted from the unreconciled book
balance of cash on the bank reconciliation. Why? Because the cash balance reported on
the books is overstated by $270 because of the error. Each error requires careful analysis to
determine whether it will be added or subtracted in the unreconciled book balance of cash on
the bank reconciliation.
Bank Reconciling Items
Cash receipts are recorded as an increase of cash in the company’s accounting records when
they are received. These cash receipts are deposited by the company into its bank. The bank
records an increase in cash only when these amounts are actually deposited with the bank.
Since not all cash receipts recorded by the company will have been recorded by the bank when
the bank statement is prepared, there will be outstanding deposits, also known as deposits
in transit. Outstanding deposits cause the bank statement cash balance to be understated.
Therefore, outstanding deposits are a reconciling item that must be added to the unreconciled
bank balance of cash on the bank reconciliation.
On the date that a cheque is prepared by a company, it is recorded as a reduction of cash

in a company’s books. A bank statement will not record a cash reduction until a cheque is
presented and accepted for payment (or clears the bank). Cheques that are recorded in the
company’s books but are not paid out of its bank account when the bank statement is prepared
are referred to as outstanding cheques. Outstanding cheques mean that the bank statement
cash balance is overstated. Therefore, outstanding cheques are a reconciling item that must
be subtracted from the unreconciled bank balance of cash on the bank reconciliation.
Bank errors sometimes occur and are not revealed until the transactions on the bank statement
are compared to the company’s accounting records. When an error is identified, the company
notifies the bank to have it corrected. Depending on the nature of the error, it is either added
to or subtracted from the unreconciled bank balance of cash on the bank reconciliation. For
example, if the bank cleared a cheque as $520 that was correctly written for $250, the $270
difference would be added to the unreconciled bank balance of cash on the bank reconciliation.
Why? Because the cash balance reported on the bank statement is understated by $270 as
a result of this error. As another example, if the bank recorded a deposit as $520 when the
correct amount was $250, the $270 difference would be subtracted from the unreconciled
bank balance of cash on the bank reconciliation. Why? Because the cash balance reported
on the bank statement is overstated by $270 because of this specific error. Each error must
be carefully analyzed to determine how it will be treated on the bank reconciliation.
Illustrative Problem—Bank Reconciliation
Assume that a bank reconciliation is prepared by Big Dog Carworks Corp. (BDCC) at April 30.
At this date, the Cash account in the general ledger shows a balance of $21,929 and includes
the cash receipts and payments shown in Figure 6.1.
Cash Acct. No. 101

Date Description Debit Credit DR/CR Balance
2020
Mar. 31 Balance DR 20673 -

Apr. 30 April cash receipts 9482 - DR 30155 -
30 April cash payments 8226 - DR 21929 -
Remember, ‘DR’ (debit) denotes a

positive cash balance in the far right-
hand column of the general ledger.
Figure 6.1: Big Dog’s General Ledger ‘Cash’ Account at April 30
Extracts from BDCC’s accounting records are reproduced with the bank statement for April in
Figure 6.2.
PER COMPANY RECORDS PER BANK RECORDS
Outstanding cheques
at March 31:
Cheque No. Amount Step 1a: March 31
outstanding cheques are
580 $4,051 x compared with cheques
599 196 x cashed to see if any are
600 7x still outstanding at April
30. Cleared items are
marked with an ‘x’.
Cheques written
during month of April:
Cheque No. Amount
601 $ 24 x Step 1b: Cheques The BDCC bank statement for the month
written are compared of April is as follows:
602 1,720 x
with the cleared cheques
603 230 x on the bank statement
604 200 x to identify which ones Second Chartered Bank
have not cleared the
605 2,220 x bank (outstanding Bank Statement
606 287 cheques). Cleared items for Big Dog Carworks Corp.
607 1,364 are marked with an ‘x’. For the Month Ended April 30, 2020
608 100
609 40 Step 2: Other charges Deposits/ Balance
610 1,520 made by the bank are Cheques/Charges/Debits Credits 24,927
identified (SC=service
611 124 x 4,051 x 1,570 22,446
charge; NSF=not
612 397 x sufficient funds). 196 x 24 x 230 x 390 22,386
$8,226 200 x 22,186
124 x 397 x 7x 21,658
2,220 x 180 NSF 5,000 24,258
Deposits made for 1,720 x 31 1,522 24,029
the month of April: 6 SC 24,023
Date Amount
April 5 $1,570 x
10 390 x Step 3: Deposits made Step 5: Remaining items are identified and
23 5,000 x by the company are resolved with the bank.
28 1,522 x compared with deposits
on the bank statement to
30 1,000 determine outstanding
$9,482 deposits at April 30. Step 4: Outstanding deposits from March 31 are
Cleared items are compared with the bank statement to see if they
marked with an ‘x’. are still outstanding at April 30. (There were no
outstanding deposits at March 31.)
Figure 6.2: The Bank Reconciliation Process
For each entry in BDCC’s general ledger Cash account, there should be a matching entry on
its bank statement. Items in the general ledger Cash account but not on the bank statement
must be reported as a reconciling item on the bank reconciliation. For each entry on the bank
statement, there should be a matching entry in BDCC’s general ledger Cash account. Items
on the bank statement but not in the general ledger Cash account must be reported as a
reconciling item on the bank reconciliation.
There are nine steps to follow in preparing a bank reconciliation for BDCC at April 30, 2020:
Step 1
Identify the ending general ledger cash balance ($21,929 from Figure 6.1) and list it on the
bank reconciliation as the book balance on April 30 as shown in Figure 6.3. This represents
the unreconciled book balance.
Step 2
Identify the ending cash balance on the bank statement ($24,023 from Figure 6.2) and list it
on the bank reconciliation as the bank statement balance on April 30 as shown in Figure 6.3.
This represents the unreconciled bank balance.
Step 3
Cheques written that have cleared the bank are returned with the bank statement. These
cheques are said to be cancelled because, once cleared, the bank marks them to prevent
them from being used again. Cancelled cheques are compared to the company’s list of cash
payments. Outstanding cheques are identified using two steps:
a. Any outstanding cheques listed on the BDCC’s March 31 bank reconciliation are com-
pared to the cheques listed on the April 30 bank statement.
For BDCC, all of the March outstanding cheques (nos. 580, 599, and 600) were paid
by the bank in April. Therefore, there are no reconciling items to include in the April 30
bank reconciliation. If one of the March outstanding cheques had not been paid by the
bank in April, it would be subtracted as an outstanding cheque from the unreconciled
bank balance on the bank reconciliation.
b. The cash payments listed in BDCC’s accounting records are compared to the cheques
on the bank statement. This comparison indicates that the following cheques are out-
standing.
Cheque No. Amount

606 $ 287
607 1,364
608 100
609 40
610 1,520
Outstanding cheques must be deducted from the bank statement’s unreconciled ending
cash balance of $24,023 as shown in Figure 6.3.
Step 4
Other payments made by the bank are identified on the bank statement and subtracted from
the unreconciled book balance on the bank reconciliation.
a. An examination of the April bank statement shows that the bank had deducted the NSF
cheque of John Donne for $180. This is deducted from the unreconciled book balance
on the bank reconciliation as shown in Figure 6.3.
b. An examination of the April 30 bank statement shows that the bank had also deducted a
service charge of $6 during April. This amount is deducted from the unreconciled book
balance on the bank reconciliation as shown in Figure 6.3.
Step 5
Last month’s bank reconciliation is reviewed for outstanding deposits at March 31. There were
no outstanding deposits at March 31. If there had been, the amount would have been added
to the unreconciled bank balance on the bank reconciliation.
Step 6
The deposits shown on the bank statement are compared with the amounts recorded in the
company records. This comparison indicates that the April 30 cash receipt amounting to
$1,000 was deposited but it is not included in the bank statement. The outstanding deposit is
added to the unreconciled bank balance on the bank reconciliation as shown in Figure 6.3.
Step 7
Any errors in the company’s records or in the bank statement must be identified and reported
on the bank reconciliation.
An examination of the April bank statement shows that the bank deducted a cheque issued by
another company for $31 from the BDCC bank account in error. Assume that when notified,
the bank indicated it would make a correction in May’s bank statement.
The cheque deducted in error must be added to the bank statement balance on the bank
reconciliation as shown in Figure 6.3.
Step 8
Total both sides of the bank reconciliation. The result must be that the book balance and
the bank statement balance are equal or reconciled. These balances represent the adjusted
balance.
The bank reconciliation in Figure 6.3 is the result of completing the preceding eight steps.
Big Dog Carworks Corp.

Bank Reconciliation
At April 30, 2020
Book balance at Apr. 30 $21,929 Bank statement balance at Apr. 30 $24,023

Add: Outstanding deposit 1,000
Cheque deducted in error 31
25,054
Less: Bank charges $6 Less: Outstanding cheques
NSF Cheque – J. Donne 180 186 Cheque No. Amount
606 $ 287
607 1,364
608 100
609 40
610 1,520 3,311
Adjusted book balance at Apr. 30 $21,743 Adjusted bank balance at Apr. 30 $21,743
These balances must agree.
Reconciling items in this section require Reconciling items in this section do

journal entries to be made in the general not require journal entries because
journal to correct the unreconciled Cash the outstanding deposits and cheques
balance of $21,929 in the general ledger to should clear the bank next month, in May.
the reconciled balance of $21,743. Additionally, the other reconciling items
(e.g., the $31 cheque deducted in error)
must be reported to the bank so it can
make the necessary corrections to Big
Dog’s account in the next month.
Figure 6.3: BDCC’s April Bank Reconciliation
Step 9
For the adjusted balance calculated in the bank reconciliation to appear in the accounting
records, an adjusting entry(s) must be prepared.
The adjusting entry(s) is based on the reconciling item(s) used to calculate the adjusted book
balance. The book balance side of BDCC’s April 30 bank reconciliation is copied to the left
below to clarify the source of the following April 30 adjustments.
Book balance at Apr. 30 $21,929 Bank Service Charges Expense . . . . . . . . . . . . . . . 6

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
To record service charges from April 30 bank
Less: Bank charges $6 reconciliation.
NSF Cheque – J. Donne 180 186
Accounts Receivable – J. Donne . . . . . . . . . . . . . . 180
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180
To record NSF cheque from April 30 bank reconciliation.
Adjusted book balance at Apr. 30 $21,743
It is common practice to use one compound entry to record the adjustments resulting from a
bank reconciliation as shown below for BDCC.
Once the adjustment is posted, the Cash general ledger account is up to date, as illustrated in
Figure 6.4.
Bank Service Charges Expense . . . . . . . . . . . . . . . . . . . . . . 6

Accounts Receivable – J. Donne . . . . . . . . . . . . . . . . . . . . . 180
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
To record reconciling items from April 30 bank reconciliation.
Cash Acct. No. 101

Date Description Debit Credit DR/CR Balance
2020
Mar. 31 Balance DR 20673 -

Apr. 30 April cash receipts 9482 - DR 30155 -
30 April cash payments 8226 - DR 21929 -
30 Bank charge expense 6- DR 21923 -
30 NSF cheque 180 - DR 21743 -
This adjusted cash balance now

agrees with the bank reconciliation.
Figure 6.4: Updated Cash Account in the General Ledger
Note that the balance of $21,743 in the general ledger Cash account is the same as the
adjusted book balance of $21,743 on the bank reconciliation. Big Dog does not make any
adjusting entries for the reconciling items on the bank side of the bank reconciliation since
these will eventually clear the bank and appear on a later bank statement. Bank errors will be
corrected by the bank.
Chapter Summary 239
Chapter Summary
LO 1: Describe cash and receivables, and explain their role in accounting and
business.
Companies usually have significant amounts of accounts receivable and the time frame and
effort required to convert receivables to cash is a cycle that calls for regular monitoring for
which financial reporting plays a significant role. Cash and receivables are financial assets
defined as cash or a contractual right to receive cash or another financial asset from another
entity. Cash and receivables are also monetary assets because they represent a claim to cash
where the amount is fixed by contract.
Cash and receivables need to be kept in balance for the company to be financially stable. Too
many accounts receivable may mean a substandard credit policy, resulting in significant uncol-
lectible accounts. Too few accounts receivable could be an indication that the company’s credit
policy is too restrictive, resulting in missed sales opportunities. Effective cash management is
essential to ensure that any surplus cash is invested appropriately to maximize interest income
and to minimize any bank loans and other borrowings.
LO 2: Describe cash and cash equivalents, and explain how they are measured
and reported.
Cash is the most liquid asset and if unrestricted is usually classified as a current asset. Cash
consists of coins, currency, bank accounts and petty cash funds, and negotiable instruments
such as money orders, cheques, and bank drafts. Temporary same-bank overdrafts are
usually netted with the current cash balance. Foreign currencies are reported in Canadian
dollars as at the balance sheet date. Cash balances set aside for long-term purposes, such as
a plant expansion project or long-term debt retirement, are classified long-term assets. Legally
restricted or compensating balances are reported separately as current or non-current assets
depending on the classification of the account it is supporting.
Cash equivalents are short-term, highly liquid assets with maturities no longer than three
months (or ninety days) at acquisition that can be converted into known amounts of cash.
Cash equivalents are usually combined with cash and reported in a single cash and cash
equivalents account on the balance sheet. Examples are treasury bills, money market funds,
short-term notes receivable, and guaranteed investment certificates (GICs).
LO 3: Describe receivables, identify the different types of receivables, explain

their accounting treatment, and prepare the relevant journal entries.
Receivables are claims held against customers and debtors that are contractual rights with
a legal claim to receive cash or other financial assets. They can be classified as current or
long-term and are initially reported at their fair value. Subsequently they are measured at
amortized cost. Categories include trade (accounts) receivable, notes receivable, and non-
trade receivables.
Accounts receivable are usually collected within one year, so the interest component is not
significant. Measurement in lieu of fair value is net realizable value. This is equivalent to
the transaction value on the date the credit sale initially occurred and adjusted by any trade
or sales discounts, sales returns, and allowances. Subsequent measurement is at cost (in
lieu of amortized cost, since there is no interest component to amortize). Accounts receivable
are affected by credit risk which may result in impairment of the accounts thereby reducing
their net realizable value. This requires estimating an amount for uncollectible accounts that
can be recorded to a valuation account called an allowance for doubtful accounts (AFDA). The
AFDA is a contra account to accounts receivable and the net of the two accounts is intended to
reflect the accounts receivable’s net realizable value. The calculations to estimate uncollectible
accounts will be completed at each reporting date using either a percentage of accounts
receivable, percentages applied to the accounts receivable aging report, a percentage of credit
sales, or a mix of these methods. Whenever an actual account is deemed uncollectible, it is
written-off by removing it from the accounts receivables and AFDA accounts.
Notes receivable are a written promise to pay a specific sum of money on demand or on a
defined future date. Payments can be a single lump sum at maturity, a series of payments, or a
combination of both. Notes may be referred to as interest bearing or non-interest-bearing, even
though there is always an interest component that must be recognized. For interest-bearing
notes, the interest paid is equal to the stated interest rate on the note. For non-interest-bearing
notes, the interest paid is the difference between the amount lent (proceeds) and the (higher)
amount paid at maturity. Notes may be classified as short-term (less than twelve months) or
long-term. Notes are initially measured at their fair value including transaction fees on the date
that the note is legally executed. For short-term notes, since the effects of the discounted cash
flows are insignificant, the net realizable value is used to approximate fair value. For long-term
notes, fair value is equal to the present value of the expected future cash flows discounted by
the market rate at the time of note issuance. After issuance, long-term notes receivable are
measured at amortized cost, which allocates the interest income and discount or premium,
if any, over the term of the note. For ASPE, either the effective interest rate method or the
straight-line method can be used for amortization purposes. For IFRS, the effective interest
rate method is to be used.
Non-trade receivables are amounts due for item such as income tax refunds, GST/HST receiv-
able, amounts due from the sale of assets, insurance claims, advances to employees, amounts
due from officers of the company, or dividends receivable.
Chapter Summary 241
To shorten the cycle of receivables to cash, companies can arrange for a borrowing (loan)
from a financial institution (using the receivables as collateral) or as a sale of the receivables
to another entity for cash. Sales can be either factoring or securitization. Factoring involves
a financial intermediary (factor), such as a finance company that purchases the receivables
and collects from the customers. Securitization is more complex; it involves a special purpose
entity or vehicle (SPV) set up by a financial institution that purchases the receivables from
the transferor using proceeds obtained from selling debt instruments to investors. These debt
instruments are secured by the receivables received from the transferor. Companies selling
receivables may or may not have continuing involvement regarding the transferred receivables.
The issue becomes whether the transfer should be treated as a secured borrowing or a sale.
For IFRS, receivables are treated as a sale if the risks and rewards have substantially been
transferred. This is evidenced by the contractual rights to cash flows being transferred or
the company continues to collect but immediately passes the proceeds on to the entity that
purchased the receivables. As well, the company cannot sell or pledge the receivables to any
other party. For ASPE, the focus is on control of the receivables. Three conditions must be
met for control to occur and for receivables to be treated as a sale.
IFRS disclosures of receivables involve levels of significance and the nature and extent of the
risks arising from them and how these risks are managed. Separate reporting is required for:
• trade accounts receivable from non-trade accounts
• current accounts receivable from non-current
• disclosures of any impairments or reversals of impairments
• details regarding any allowance accounts.
Other disclosures require details about the carrying amounts such as fair values, amortized
costs or costs where applicable, and methods used for estimating uncollectible accounts. For
long-term receivables, the amounts and maturity dates are to be disclosed. Information about
any assets pledged or held as collateral is to be disclosed. Extensive disclosures are required
for any securitization or transfers of receivables. Various types of risks such as credit, liquidity
and market risks are to be disclosed. Companies following ASPE require less disclosure than
IFRS companies.
LO 4: Identify the different methods used to analyze cash and receivables.
Cash and receivables are analyzed using various techniques to determine the levels of risk for
uncollectible accounts as well as the company’s overall liquidity or solvency. The statement
of cash flows provides information about the sources and uses of cash. Receivables can
be analyzed using accounts receivable aging reports, trendline analysis, and various ratio
analyses such as quick and current ratios, accounts receivable turnover ratios, and days’ sales
uncollected.
LO 5: Explain the differences between IFRS and ASPE for recognition,

measurement, and reporting for cash and receivables.
For the most part, the IFRS and ASPE standards are similar. The differences between IFRS
and ASPE arise regarding: 1) what is recognized as cash equivalents; 2) the method used to
amortize interest, premiums, or discounts for long-term receivables; 3) the criteria needed for
treatment as either a sale of receivables or as a secured borrowing; and 4) both the nature
and extent of disclosing requirements for cash and receivables on the balance sheet.
References
Apple Inc. (2013). Annual report for the fiscal year ended September 28, 2013. Retrieved
from http://files.shareholder.com/downloads/AAPL/3038213857x0x701402/a406ad58
-6bde-4190-96a1-4cc2d0d67986/AAPL_FY13_10K_10.30.13.pdf
IFRS. (2015). International Financial Reporting Standards 2014. London, UK: IFRS Founda-
tion Publications Department.
International Accounting Standards. (2017). IFRS 9–Financial Instruments. Retrieved from h

ttp://www.iasplus.com/en/standards/ifrs/ifrs9
Jobst, A. (2008). What is securitization? Finance & Development, 45(3), 48–49. Retrieved
from http://www.imf.org/external/pubs/ft/fandd/2008/09/basics.htm
Exercises
EXERCISE 6–1
Below is a list of various items. For each item, determine the amount that should be reported
as cash or cash equivalent. For all other items, identify the proper disclosure.
a. Chequing account balance $600,000

Exercises 243
b. Short-term (60-day) treasury bills $22,000
c. Cash advance received from a customer $2,670
d. Cash advance of $5,000 to company executive, payable on demand
e. Refundable deposit of $13,000 paid to developer to guarantee performance on a con-

struction contract
f. Cash restricted for future plant expansion $545,000
g. Certificate of deposit $575,000, maturing in nine months
h. Utility deposit paid to utility company $500
i. Cash advance to subsidiary $100,000
j. Post-dated cheque from customer $30,000
k. Cash restricted to maintain compensating balance requirement $115,000, considered to

be significant
l. Certified cheque from customer $13,000
m. Postage stamps on hand $1,115
n. Savings account balance $545,000 and overdraft in special chequing account at same
bank as normal chequing account $25,000
o. Cash held in non-current bond sinking fund $150,000
p. Petty cash fund $1,200
q. Cash on hand $13,000
r. Money-market balance at mutual fund with chequing privileges $75,400
s. NSF cheque received from the bank for a customer $8,000
EXERCISE 6–2
Below is financial information for Overachiever Ltd. The company’s year-end is December 31.
i. A commercial savings account with $575,000 and a commercial chequing account with
$450,000 are held at First Royal Bank. There is also a bank overdraft of $150,000 in a
chequing account at the Lemon Bank. It is the only account held at the Lemon Bank.
ii. The company must maintain a minimum cash balance of $175,000 with First Royal Bank
in order to retain its overdraft privileges.
iii. A separate cash fund for $2 million is restricted for the retirement of long-term debt.
iv. There are five cash floats for retail operation cash registers for $250 each.
v. Currency and coin on hand amount to $15,000.
vi. The petty cash fund has $1,500.
vii. The company has received a cheque dated January 18, 2021, in the amount of $12,500
from a customer for an amount owing as at December 31.
viii. The company has received a cheque dated January 12, 2021, in the amount of $1,800
from a customer as payment in advance for an order placed on December 27. Goods
will be delivered FOB destination on January 20, 2021.
ix. There are cash advances for $15,000 paid for executive travel to occur in the first quarter
of next year. These travel advances will be recovered from the travel expense reports
after they travel.
x. An employee owes $2,300 that was borrowed from the company and will be withheld
from his salary in January 2021.
xi. The company has invested $2.5 million in money market funds (with chequing privileges)
maturing in 2 months at the Commercial Bank of British Columbia.
xii. The company has a 180-day treasury bill for $50,000. It was purchased on November
22.
xiii. The company has a 60-day treasury bill for $18,000. It was purchased on December 15.
xiv. The company holds commercial paper for $1.56 million from Ace Furniture Co., which is
due in 145 days.
xv. The company acquired 1,000 shares of Highland Ltd. for $3 per share on July 31 and
is holding them for trading. The shares are still on hand as at December 31 have a fair
value of $4.06 per share on December 31, 2020.
Required:
a. Prepare a partial statement of financial position (balance sheet) as at December 31,

2020, reporting any cash balances.
b. For any items not reported in (a) above, indicate the proper way to disclose them.
Exercises 245
EXERCISE 6–3
Amy Glitters Ltd. provides you with the following information about its accounts receivable at
December 31, 2020:
Due from customers, of which $30,000 has been pledged as security for a bank loan $275,000
Instalment accounts due after December 31, 2021 50,000
Advances to employees 2,500
Advances to a related party (originated in 2015) 30,000
Overpayments made to a supplier 6,000
Required: Prepare a partial classified balance sheet at December 31, which is their year-end.
Make the required disclosures in parentheses after the line item account.
EXERCISE 6–4
From July 1 to August 30, 2020, Busy Beaver Ltd. completed the following transactions:
On July 1, Busy Beaver sold 40 computers at a unit price of $3,000 to Heintoch Corp., terms
1/15, n/30. Average cost for these computers was $1,500. Busy Beaver also paid the freight
costs of $3,200 cash. On July 5, Heintoch Corp. returned for full credit three damaged
computers from the July 1 shipment. These were not returned to inventory. Heintoch agreed
to pay the $240 freight cost to return the computers to Busy Beaver. On July 10, Busy Beaver
received payment from Heintoch for the full amount owed from the July transactions. On July
14, Busy Beaver purchased 50 computers on account from Correl Computers Ltd. for $1,500
per unit plus freight for $4,000. On July 17, Busy Beaver sold $224,000 in computers and
peripherals to Perkins Store, terms 1.5/10, n/30. Cost for these computers was $112,000. On
July 26, Perkins Store paid Busy Beaver for half of its July purchases. On August 30, Perkins
Store paid Busy Beaver for the remaining half of its July purchases. Busy Beaver uses the
perpetual inventory system.
Required:
a. Prepare the entries for Busy Beaver Computers Ltd., assuming the gross method is used
to record sales and sales discounts.
b. Assume that Heintoch has access to a bank line of credit facility at a rate of 8%. Is it a
good idea to pay within the discount period? Explain your answer using data from the
question.
c. Prepare the entries for July and August, assuming Busy Beaver is an IFRS company that
uses the net method to record sales and sales discounts. Also assume that on August
30 year-end, Busy Beaver estimates sales returns and allowances to be $44,000 for the
year just ended, which it considers to be significant. The unadjusted balance of its refund
liability account prior to the July and August transactions was $23,000 credit.
EXERCISE 6–5
The following information is available for Inverness Ltd.’s second year in business:
• Opening merchandise inventory is $35,000.
• Goods are marked to sell at 35% above cost.
• Merchandise purchased totalled $600,000.
• Collections from customers are $420,000.
• Ending merchandise inventory is $225,000.
• Opening accounts receivable balance is $0.
• Ending accounts receivable balance is $85,000.
Required:
a. Estimate the ending accounts receivable that should appear in the ledger. Calculate any
shortages, if any. Assume that all sales are made on account.
b. What controls can be put in place to prevent theft?
EXERCISE 6–6
The trial balance before adjustment of Cyncrewd Inc. shows the following balances:
Dr. Cr.
Allowance for doubtful accounts (AFDA) 2,340
Credit sales 375,000
Sales returns 35,000
Required:
Exercises 247
a. Give the entry for bad debt expense for the current year assuming:
• The allowance should be 4% of gross accounts receivable.

• Historical records indicate that based on accounts receivable aging the following
statistics apply:
Balance Percentage Estimated

to be Uncollectible
0–30 days outstanding $141,000 1%
31–60 days outstanding 53,500 3%
61–90 days outstanding 10,500 8%
Over 90 days outstanding 20,000 14%
• Allowance for doubtful accounts is $2,340, but it is a credit balance, and the al-
lowance should be 2% of gross accounts receivable.
b. What could account for the unadjusted debit balance in the AFDA account for $2,340?
EXERCISE 6–7
At January 1, 2020, the credit balance of Reimer Corp.’s allowance for doubtful accounts
was $575,000. During 2020, the bad debt expense entry was based on a percentage of net
credit sales. Net sales for 2020 were $16 million, of which 75% were on account. Based on
the information available at the time, the 2020 bad debt expense was estimated to be 1% of
net credit sales. During 2020, uncollectible receivables amounting to $40,000 were written off
against the allowance for doubtful accounts. The company has estimated that at December 31,
2020, based on a review of the aged accounts receivable, the allowance for doubtful accounts
would be properly measured at $500,000.
Required:
a. Prepare a schedule calculating the balance in Reimer Corp.’s allowance for doubtful
accounts at December 31, 2020. Prepare any necessary journal entry at year-end to
adjust the allowance for doubtful accounts to the required balance.
b. If accounts receivable balance at December 31 was $50,950,000, prepare a partial

classified balance sheet at December 31, 2020 for Reimer. What is the net accounts
receivable balance intended to measure?
c. Under what conditions is using the direct write-off method justified?
EXERCISE 6–8
On May 1, 2020, Effix Ltd. provided services to Harper Inc. in exchange for Harper’s $336,000,
five-year, zero-interest-bearing note. The implied interest is 8%. Effix’s year-end is December
31.
Required:
a. Prepare Effix’s entries for the note, the interest entries over the five years and the
collection of the note at maturity.
b. Using present value calculations prove that the note yields 8%.
c. Prepare a partial classified balance sheet as at December 31, 2021. What would be
the unamortized discount/premium, if any? How would the classification of the note
receivable differ on the partial classified balance sheet as at December 31, 2024?
d. If an appropriate market rate of interest for the note receivable is not known, how should
the transaction be valued and recorded on December 31, 2020?
EXERCISE 6–9
Below are three unrelated scenarios:
i. On July 1, a one-year note for $120,000 was accepted in exchange for an unpaid
accounts receivable for $120,000. Interest for 5% would be payable at maturity.
ii. On July 1, a one-year non-interest-bearing note for $110,250 was accepted in exchange
for an unpaid accounts receivable for $105,000. The market rate of interest at that time
was 5%.
iii. On July 1, a one-year 10% note for $115,000 was accepted in exchange for unpaid
accounts receivable $104,545 from a higher-risk customer. The customer’s borrowing
interest rate at that time was 10%.
Required:
a. Prepare the entries to recognize the notes payable and accrued interest, if any. The
year-end is December 31.
b. Assume that for item (iii) above, the borrower faces financial difficulties and can only pay
75% of the note’s maturity amount. After a thorough analysis, the creditor determines
that the 25% remaining is uncollectible. Prepare the entry for the note at maturity.
Exercises 249
EXERCISE 6–10
On January 1, Harrison Corp. sold used vehicles with a cost of $78,000 and a carrying amount
of $12,600 to Aberdeen Ltd. in exchange for a $18,000, four-year non-interest-bearing note
receivable. The market rate of interest for a note of similar risk is 7.5%. Harrison follows IFRS
and has a year-end of December 31.
Required:
a. Prepare the entries to record the sale of equipment in exchange for the note, the interest
for the first year, and the collection of the note at maturity.
b. Prepare the interest entry for the first year assuming that Harrison follows ASPE and
uses the straight-line method for interest.
EXERCISE 6–11
On July 1, 2020, Helim Ltd. assigns $800,000 of its accounts receivable to Central Bank of
Tasmania as collateral for a $500,000 loan that is due October 1, 2020. The assignment
agreement calls for Helim to continue to collect the receivables. Central Bank assesses a
finance fee of 3.5% of the accounts receivable, and interest on the loan is 7.5%, a realistic rate
for a note of this type and risk.
Required:
a. Assuming the transaction does not qualify as a sale, prepare the July 1, 2020 journal
entry for Helim Ltd.
b. Prepare the journal entry for Helim’s collection of $750,000 of the accounts receivable
during the period July 1 to September 30, 2020.
c. On October 1, 2020, Helim paid Central Bank the entire amount that was due on the
loan.
d. Explain the differences between IFRS and ASPE regarding the sale of receivables com-
pared to a secured borrowing.
e. Explain if management would prefer the transaction to be reported as a sale of receiv-

ables or a secured borrowing and why.
EXERCISE 6–12
Browing Sales Ltd. sells $1,450,000 of receivables with a fair value of $1,500,000 to Finnish
Trust in a securitization transaction that meets the criteria for a sale. Browing receives the
full fair value of the receivables and agrees to continue to service them. The fair value of the
service liability component is estimated as $250,000.
Required: Prepare the journal entry for Browing to record the sale.
EXERCISE 6–13
Jertain Corporation factors $800,000 of accounts receivable with Holistic Financing Inc. on a
with recourse basis. Holistic Financing will collect the receivables. The receivable records are
transferred to Holistic Financing on February 1, 2020. Holistic Financing assesses a finance
charge of 2.5% of the amount of accounts receivable and also reserves an amount equal to 4%
of accounts receivable to cover probable adjustments. Jertain prepares financial statements
under ASPE and has a year-end of December 31.
Required:
a. Assuming that the conditions for a sale are met, prepare the journal entry on February
1, 2020, for Jertain to record the sale of receivables, assuming the recourse obligation
has a fair value of $10,000.
b. What effect will the factoring of receivables have on calculating the accounts receivable
turnover for Jertain?
EXERCISE 6–14
On July 1, 2020, Brew It Again Ale Co. sold excess land in exchange for a three-year, non-
interest-bearing promissory note in the face amount of $530,000. The land’s carrying value is
$250,000.
On September 1, Brew It Again Ale rendered services in exchange for a six-year promissory
note having a face value of $500,000. Interest at a rate of 3% is payable annually.
For both transactions, the customers are able to borrow money at 11% interest. Brew It Again
Ale’s cost of capital is 7.4%.
On October 1, 2020, Brew It Again Ale agreed to accept an instalment note from one if its
Exercises 251
customers, in partial settlement of accounts receivable that were overdue. The note calls for
five equal payments of $12,000, including the principal and interest due, on the anniversary of
the note. The implied interest rate on this note is 12%.
Required:
a. Prepare the journal entries to record the three notes receivable for Brew It Again Ale Co.
for 2020 fiscal year.
b. Prepare an effective-interest amortization table for the instalment note obtained in partial
collection of accounts receivable. Brew It Again Ale’s year-end is December 31. Prepare
the year-end journal entry and the first cash payment entries for the first year.
c. From Brew It Again Ale’s perspective, what are the advantages of an instalment note
compared with a non-interest-bearing note?
EXERCISE 6–15
The following information below relates to Petervale Corporation for 2020:
• The beginning of the year net Accounts Receivable balance was $123,000.
• Net sales for the year were $1,865,000. Credit sales were 54.8% of the total sales and
no cash discounts are offered.
• Collections on accounts receivable during the year were $863,260, and uncollectible
accounts written off in 2020 were $12,500. The AFDA account ending balance for 2020
needed no further adjustment for estimated uncollectible accounts at year-end.
Required:
a. Calculate Petervale Corporation’s accounts receivable turnover ratio for the year. How
old is the average receivable?
b. Use the turnover ratio calculated in part (a) to analyze Petervale Corporation’s liquidity.
The turnover ratio last year was 5.85.
EXERCISE 6–16
Jersey Shores Ltd. sold $1,250,000 of accounts receivable to Fast Factors Inc. on a without re-
course basis. The transaction meets the criteria for a sale, and no asset or liability components
of the receivables are retained by Jersey Shores. Fast Factors charges a 3.5% finance fee and
retains another 5% of the total accounts receivable for estimated returns and allowances.
Required:
a. Prepare the journal entries for both companies.
b. Assume instead, that Jersey Shores follows ASPE and sells the accounts receivable
with recourse. The recourse obligation has a fair value of $7,400. Prepare the journal
entries for the sale by Jersey Shores.
EXERCISE 6–17
Opal Co. Ltd. transfers $400,000 of its accounts receivable to an independent trust in a
securitization transaction on July 11, 2020, receiving 95% of the receivables balance as
proceeds. Opal will continue to manage the customer accounts, including their collection.
Opal estimates this obligation has a fair value of $14,000. In addition, the agreement includes
a recourse provision with an estimated value of $12,000. The transaction is to be recorded as
a sale.
Required: Prepare the journal entry on July 11, 2020, for Opal Co. Ltd. to record the securiti-
zation of the receivables, assuming it follows ASPE.
Chapter 7
Inventory
Too Much Inventory
BlackBerry Ltd. faced a rough week in late September 2013. Within a seven-day period,
the company not only announced a potential buyer for the company but also reported a
quarterly loss of close to a billion dollars. The loss was generated primarily by write-down
of BlackBerry 10 handsets (BB 10), the company’s new flagship product. Prior to this
result, the company had been struggling to keep up with other smartphone competitors,
and sales of the new phone had not met expectations. As a result of the news reported
during this week, the company’s share price fell over 20 percent on the market.
When the company reported its annual financial results for the year ended March 1, 2014,
the gross profit on hardware sales was actually negative. In fact, it was – $2.5 billion.
How can a company report a negative gross profit? In BlackBerry’s case, a further write-
down of the BB 10 handset occurred in the third quarter, resulting in total write-downs
for the year of approximately $2.4 billion. As described in the company’s Management
Discussion and Analysis of Financial Condition report, evaluations of inventory require an
assessment of future demand assumptions (BlackBerry Ltd., 2014). Sales of the new
BlackBerry product were significantly lower than expected, resulting in a large number of
unsold handsets. As the goal of financial reporting is to portray the economic truth of a
company, BlackBerry Ltd. had no choice but to accept the reality that their inventory of BB
10 phones could not be sold for the amount reported on the balance sheet. The company
described the causes of the write-down as these: the maturing smartphone market, very
intense competition, and uncertainty created by the company’s strategic review process.
Regardless of the causes, it was clear that this massive write-down had a profound ef-
fect on BlackBerry Ltd.’s financial results and share price. Although the write-down was
a symptom of other deeper problems in the company, it is clear that management of
inventory levels can be a significant issue for many businesses. For the accountant,
understanding the importance of the reported inventory amount is paramount, and critically
analyzing the valuation assumptions is essential to fair reporting of inventory balances.
(Sources: BlackBerry Ltd., 2014; Damouni, Kim & Leske, 2013)
253
254 Inventory
LO 1: Define inventory and identify those characteristics that distinguish it from other assets.
LO 2: Identify the types of costs that should be included in inventory.
LO 3: Identify accounting issues and treatments applied to inventory subsequent to its pur-
chase.
LO 3.1: Describe the differences between periodic and perpetual inventory systems.
LO 3.2: Identify the appropriate criteria for selection of a cost flow formula and apply
different cost flow formulas to inventory transactions.
LO 3.3: Determine when inventories are overvalued and apply the lower of cost and net
realizable value rule to write-down those inventories.
LO 4: Describe the presentation and disclosure requirements for inventories under both
IFRS and ASPE.
LO 5: Identify the effects of inventory errors on both the balance sheet and income statement
and prepare appropriate adjustments to correct the errors.
LO 6: Calculate estimated inventory amounts using the gross profit method.
LO 7: Calculate gross profit margin and inventory turnover period and evaluate the signifi-
cance of these results with respect to the profitability and efficiency of the business’s
operations.
LO 8: Identify differences in accounting for inventories between ASPE and IFRS.
Introduction
The nature of economic activity has been evolving rapidly over the last two decades. The
knowledge economy is becoming an increasingly significant component of the world’s gross
domestic product. But even in the wired world of services and data, there is always a need for
physical products. The concept of retail business may be changing through the development
of online shopping, but consumers still expect to receive their goods eventually. This chapter
will deal with some accounting issues surrounding the acquisition, production, and sale of
inventory items, and it will discuss some of the problems that can arise when errors are made
in the recording of inventory items.
1.0 Definition
2.0 Intial Recognition Inventory

and Measurement Accounting Systems
3.0 Subsequent
Recognition and Cost Flow Assumptions
Measurement
The Problem of
4.0 Presentation Overvaluation
and Disclosure
Inventory
5.0 Inventory Errors
6.0 Estimating Inventory
7.0 Inventory Analysis
8.0 IFRS/ASPE
Key Differences
7.1 Definition
IFRS defines inventories as assets that are:
• held for sale in the ordinary course of business,
• in the process of production for such sale, and
• in the form of materials or supplies to be consumed in the production process or in the

rendering of services (International Accounting Standards, n.d., 2.6).
The key feature of inventory is that it is held for sale in the normal course of business, which
differentiates it from other tangible assets, such as property, plant, and equipment, that are only
sold only when their productive capacity is exhausted or no longer required by the business.
256 Inventory
The definition also recognizes that for manufacturing businesses, inventory can take various
forms throughout the production process. Raw materials, work in process, and finished goods
are all considered inventory. For many businesses, inventory can represent a significant asset.
In 2013, Bombardier Inc., a manufacturer of airplanes and trains, reported total inventory of
$8.2 billion, which represented over 28 percent of the company’s total assets. In the same
year, Loblaw Companies Ltd., a grocery retailer, reported total inventory of over $2 billion.
It is not surprising that, given its significance, inventory can also be the source of various types
of accounting problems. In 2014, BlackBerry had to write off approximately $2.4 billion of its
inventory due to slow sales resulting from competitive pressures. In a more troubling series of
events, inventories of DHB Industries Inc., a manufacturer of body armour for the military and
police, were overstated by approximately $47 million in 2004. The accounting errors included
the falsification of amounts included in work in process, and raw materials and a failure to write
off significant amounts of obsolete raw materials. These accounting errors led to a Securities
and Exchange Commission (SEC) investigation and penalties.
7.2 Initial Recognition and Measurement
An obvious question that arises when considering inventory is, what costs should be included?
In answering this question, IFRS has provided some general guidance: the cost of inventories
shall include all costs of purchase, costs of conversion, and “other costs incurred in bringing
the inventories to their present location and condition” (International Accounting Standards,
n.d., 2.10).
Costs of Purchase
Purchase costs include not only the direct purchase price of the goods but also the costs to
transport the goods to the company’s premises and any nonrecoverable taxes or import duties
paid on the purchase. As well, any discounts or rebates earned on the purchase should be
deducted from the cost of the inventory.
One issue that often needs to be considered when determining inventory costs at the end of an
accounting period is the matter of goods in transit. Goods may be shipped by a seller before
the end of an accounting period but are not received until after the end of the purchaser’s
accounting period. The question of who owns the goods while they are in transit obviously
needs to be addressed. More specifically, three issues arise from this question:
1. Who pays for the shipping costs?
2. Who is responsible for the loss if goods are damaged in transit?
3. When should the transfer of ownership be recorded in the accounting records?

7.2. Initial Recognition and Measurement 257
To answer these questions, the legal term free on board (FOB) needs to be understood. When
goods are shipped by a seller, the invoice will usually indicate that the goods are shipped either
FOB shipping or FOB destination. If the goods are FOB shipping, the purchaser is assuming
legal title as soon as the goods leave the seller’s warehouse. This means the purchaser is
responsible for shipping costs as well as for any damage that occurs in transit. As well, the
purchaser should record these goods in his or her inventory accounts as soon as they are
shipped, even if they don’t arrive until after the end of the accounting period. If the goods
are FOB destination, the purchaser is not assuming ownership of the goods until they are
received. This means that the seller would be responsible for shipping costs and any damage
that occurs in transit. As well, the purchaser should not include these goods in his or her
inventory until they are actually received. Likewise, the seller would still include the goods in
his or her inventory until they are actually delivered to the purchaser. Accountants and auditors
pay close attention to the FOB terms of purchases and sales near the fiscal period end, as
these terms can affect the accurate recording of the inventory amount on the balance sheet.
Costs of Conversion
Another more complex issue arises in the determination of the cost of manufactured inven-
tories. As noted above, IAS 2-10 requires the inclusion of costs to convert inventories into
their current form. For a manufacturing company, this means that inventories will include
raw materials, work in progress, and finished goods. For raw materials, the cost is fairly
easy to determine. However, for work in progress and finished goods, the determination of
which costs to include becomes more complicated. Although labour and variable overhead
costs, such as utilities consumed by operating factory machines, are fairly easy to associate
directly with the production of a product, the treatment of other fixed overhead costs is not
as clear. It can be argued that costs such as factory rent should not be included in the
inventory cost because this cost will not vary with the level of production. However, it can
also be argued that without the payment of rent, the production process could not occur. For
management accounting purposes, a variety of methods are used to account for overhead
costs. For financial accounting purposes, however, it is clear that all conversion costs need
to be included in inventory. Thus, the financial accountant will need to determine the best
way to allocate fixed overhead costs. In normal circumstances, the fixed overhead costs
are simply allocated to each unit of inventory produced in an accounting period. However,
if production levels are significantly higher or lower than normal levels, then the accountant
needs to apply some judgment to the situation. If fixed overhead costs are applied to very low
levels of production, the result would be inventory that is carried at a value that may be higher
than its realizable value. For this reason, fixed overhead costs should be allocated to low
production volumes using the rate calculated on normal production levels, with unallocated
overhead being expensed in the period. This is done to avoid reporting misleadingly high
inventory levels. On the other hand, if abnormally high production occurs, the fixed overhead
costs are allocated using the actual production level. This would result in lower per-unit costs
for the inventory produced. This situation could result in higher profits, as presumably some of
the excess production would be held in inventory at the end of the year. A manager may
be tempted to increase production strictly for the purpose of increasing current earnings.
Although this does not violate any accounting standard, the accountant should be careful
258 Inventory
in this situation, as there may be a risk of obsolete inventory as a result of the overproduction,
or there may be other forms of income-maximizing earnings management occurring.
Other Costs
IAS 2–15 indicates that other costs can be included in inventory only to the extent “they are
incurred in bringing the inventories to their present location and condition.” The standard
provides examples such as certain non-production overhead costs or product-design costs
for specific customers. Clearly, the accountant would need to exercise judgment in allocating
these kinds of costs to inventory. The standard also clearly defines some costs that should not
be included in inventories but rather expensed in the current period. These costs include the
following:
• Abnormal amounts of wasted materials, labour, or other production costs
• Storage costs, unless those costs are necessary in the production process before a
further production stage
• Administrative overheads that do not contribute to bringing inventories to their present

location and condition
• Selling costs
As well, IAS 23–Borrowing Costs describes some limited and specific circumstances when
interest costs can be included in inventory. IAS 2-19 also discusses inventory of a service
provider. An example of this would be a professional services firm, such as an accounting
practice. These types of firms will often track work in progress on their balance sheets.
These accounts should include only direct costs (which would primarily consist of direct and
supervisory labour) and attributable overheads. These costs should not include the costs of
any administrative or sales personnel or other non-attributable overheads, nor should they
include any mark-ups on costs that might be included in standard charge rates for customers.
7.3 Subsequent Recognition and Measurement
Once the initial inventory amounts have been determined and recorded, a number of subse-
quent accounting decisions need to be made. These decisions can be summarized in the
following questions:
• What type of inventory accounting system should be used?
• What cost flow assumption should be applied?

7.3. Subsequent Recognition and Measurement 259
• What method can be applied to ensure reported inventories are not overvalued?
We will examine each of these issues in the following sections.
7.3.1 Inventory Accounting Systems
A merchandising business can typically be engaged in thousands or millions of inventory trans-

actions each year. As well, inventory can comprise a significant proportion of a merchandising
company’s total assets. It is thus important for merchandising businesses to have robust and
accurate systems in place for gathering data on inventory transactions. The use of various
technologies, such as computers, bar codes, and RFIDs, has simplified the complex task of
gathering inventory transaction information. The use of such technologies has allowed most
businesses to implement perpetual inventory systems as their data-collection method. A per-
petual inventory system is one that tracks all inventory additions and subtractions (purchases
and sales) directly in the accounting records. Thus, at any point in time, the company can
produce an accurate income statement and balance sheet that will display the amount of the
cost of goods sold for the period and inventory balance at the end of the period. This type
of system provides more timely information to managers, which can lead to better decision
processes.
A periodic inventory system, on the other hand, does not track purchases and sales of
inventory items directly in the accounting records. Rather, purchases are tracked through
a separate purchases account, and the cost of goods sold is not recorded at all at the time
of sale. The cost of goods sold can be determined only at the end of the accounting period,
when a physical inventory count is taken, and the ending inventory is then reconciled with
the opening inventory. This type of system is less useful for management purposes, as
profitability can be determined only at the end of the accounting period. As well, the balance
sheet would not reflect the appropriate inventory balance until the period-end reconciliation
is performed. Periodic inventory systems may be appropriate for a small business where
accounting resources are limited, but improvements in technology have resulted in many
businesses switching to perpetual inventory systems.
Note that although a perpetual inventory system does result in an instantaneous update of
inventory accounts, physical inventory counts are still required under this system. There are
many situations, such as product spoilage or theft, that are not captured by perpetual inventory
systems, so it is important that companies employing these systems still physically verify the
goods at least once per year.
260 Inventory
7.3.2 Cost Flow Assumptions
The issue of cost flow assumptions can become particularly important when prices of inventory
inputs are changing. Consider a merchandising company that purchases inventory items on
a continuous basis in order to fill customer orders. At any given point during the accounting
period, the goods available for sale may consist of identical items that were purchased at
different times for different costs. The question the accountant must answer is, which costs
should be allocated to the current cost of goods sold and which costs should continue to be
held in inventory? To answer this question, the accountant can choose from three possible
methods:
• Specific identification
• Weighted average cost
• First in, first out
Specific Identification
This technique is theoretically the most correct way to allocate costs. Each unit that is sold
is specifically identified, and the cost for that unit is allocated to cost of goods sold. This
method would thus achieve the perfect matching of costs to the revenue generated. There
are, however, some disadvantages to this method. First, unless items are easy to physically
segregate, it may difficult to identify which items were actually sold. As well, although physical
segregation may be possible, this method could be expensive to implement, as a great deal
of record keeping is required. The second disadvantage of this method is its susceptibility
to earnings-management techniques. If a manager wanted to manipulate the current period
net income, he or she could do this very easily using this method by simply choosing which
items to sell and which to retain in inventory. Lower cost items could be shipped to customers,
which would result in lower cost of goods sold, higher profits, and higher inventory values on
the statement of financial position. Because of this potential problem, this technique should
be applied only in situations where inventory items are not normally interchangeable with each
other. An example of this would be the inventory held by a car dealership. Each item would
have a separate serial number and could not be substituted for another item.
Average Cost
This technique can be applied to either periodic or perpetual inventory systems by calculating
the average of all goods available for sale and then allocating the average to both the quantity
of goods sold and the quantity of goods retained in inventory. When this technique is applied to
a perpetual inventory system, it is usually referred to as a moving average cost. An example
of a moving average cost calculation is as follows:
The following transactions occurred in the month of May for PartsPeople Inc.
May 1 Opening inventory 300 units @ $3.00

May 3 Purchase 100 units @ $3.20
May 11 Sale 150 units
May 25 Sale 375 units
May 31 Ending inventory 325 units
Inventory and cost of goods sold would be calculated as follows:
Date Purchase Cost of Balance Moving Balance of

Goods Sold Average1 Units
May 1 300 × $3.00 = $3.0000 300
$900.00
May 3 100 × (300 × $3.00) + $3.0500 400
$3.20 (100 × $3.20) =
$1,220.00
May 7 200 × (300 × $3.00) + $3.1167 600
$3.25 (100 × $3.20) +
(200 × $3.25) =
$1,870.00
May 11 150 × $3.1167 450 × $3.1167 = $3.1167 450
= $467.50 $1,402.50
May 22 250 × (450 × $3.1167) + $3.1821 700
$3.30 (250 × $3.30) =
$2,227.50
May 25 375 × $3.1821 325 × $3.1821 = $3.1821 325
= $1,193.30 $1,034.20
The total cost of goods sold for the period is ($467.50 + $1,193.30) = $1,660.80, and the
ending inventory balance is $1,034.20. Under this approach, the average inventory cost is
recalculated after each purchase, and this revised average cost is then used to determine
the cost of goods sold when a sale is made. After a sale is made, the revised average
cost becomes the new base amount for further inventory transactions until the next purchase
occurs, and a new average is determined.
This method is often used due to its simplicity and reliability. It is very difficult for managers to
manipulate income with this method, as the effects of rising or falling prices will be averaged
1
The moving average after each transaction is calculated as the total inventory balance divided by the total
number of units remaining. The calculation of cost of goods sold and ending balances are out slightly due to
rounding differences.
262 Inventory
over both the goods sold and the goods remaining on the balance sheet. As well, for goods that
are similar and interchangeable, this method may most closely represent the actual physical
flow of those goods.
First in, First out (FIFO)
Another cost-flow choice companies can use is referred to as the first in, first out method,
usually abbreviated as FIFO. This method allocates the oldest costs to goods sold first, with
newer costs remaining in the inventory balance. Assume the same set of facts for PartsPeople
Inc. used in the previous example. Under FIFO, each time a sale occurs, the oldest items are
removed from inventory first. The calculation of costs and inventory amounts would be done
as follows:
Date Purchase Sale Balance Balance of

Units
May 1 300 × $3.00 = 300
$900.00
May 3 100 × $3.20 (300 × $3.00) + 400
(100 × $3.20) =
$1,220.00
May 7 200 × $3.25 (300 × $3.00) + 600
(100 × $3.20) +
(200 × $3.25) =
$1,870.00
May 11 150 × $3.00 = (150 × $3.00) + 450
$450.00 (100 × $3.20) +
(200 × $3.25) =
$1,420.00
May 22 250 × $3.30 (150 × $3.00) + 700
(100 × $3.20) +
(200 × $3.25) +
(250 × $3.30) =
$2,245.00
May 25 (150 × $3.00) + (75 × $3.25) + 325
(100 × $3.20) + (250 × $3.30) =
(125 × $3.25) = $1,068.75
$1,176.25
In this case, the total ending inventory balance of $1,068.75 is higher than the balance calcu-
lated under the moving average cost system. This makes sense, as FIFO inventory balances
represent the most recent purchases, and in this scenario, input costs were rising throughout
the month. This feature of FIFO is considered one of its strengths, as the method results
in balance-sheet amounts that more closely represent the current replacement cost of the
inventory. Also note that the total cost of goods sold of $1,626.25 ($450.00 + $1,176.25)
is lower than moving average amount. This also makes sense, as older costs, which are
lower in this case, are being expensed first. This characteristic of FIFO is also one of its major
drawbacks. The method of expensing older costs first means that proper matching is not being
achieved, as current revenues are being matched to older costs. This method thus represents
a trade-off common in accounting standards. A more relevant balance sheet results in a less
relevant income statement. Moving average, on the other hand, averages out the differences
between the balance sheet and income statement, resulting in some loss of relevance for both
statements. As both methods are acceptable under IFRS and ASPE, management would
have to decide which statement is more important to the end users and then choose a policy
accordingly.
How to Choose?
When making an inventory cost flow assumption, what factors do managers need to consider?
Generally, the cost flow assumption should attempt to reflect the actual physical flow of goods
as much as possible. For example, a grocery retailer selling perishable merchandise may
want to use FIFO, as it is common practice to place the oldest items at the front of the rack
to encourage their sale first. Alternatively, consider a hardware store that sells bulk nails that
are scooped from a bin. There is no way to identify the individual items specifically, and it is
likely that over time, customers scooping out nails would mix together items stocked at different
times. Weighted average costing would make the most sense in this case, as this would likely
represent the real movement of the product. For a company selling heavy equipment, specific
identification would likely make the most sense, as each item would be unique with its own
serial number, and these items can be easily tracked.
A further consideration would be the effects on the income statement and balance sheet. FIFO
results in the inventory reported on the balance being reported at more current costs. As there
is an increasing emphasis in standard setting on valuation concepts, this approach would
result in the most useful information for determining the value of the company. If profitability
is more important to a financial-statement reader, then weighted average cost would be more
useful, as more current costs would be averaged into income.
Income taxes may also be a consideration when choosing a cost flow formula. This motivation
must be considered carefully, however, as income will be affected in opposite ways, depending
on whether input prices are rising or falling. As well, although taxes could be reduced in any
264 Inventory
given year through the cost flow assumption made, this is only a temporary effect, as all
inventory will eventually be expensed through cost of goods sold.
Whatever method is chosen, it should be applied on a consistent basis. It would be inap-

propriate for a company to change cost flow assumptions year to year, simply to achieve a
certain result in net income. Once the cost flow assumption is determined, it should be applied
the same way each year, unless there has been a significant change in circumstances that
warrants a change. A company may use different cost flow assumptions for different major
inventory classes, but these choices should still be applied consistently.
As a historical note, a further cost flow assumption, last in, first out (LIFO), was once available
for use. This method took the most recent purchases and allocated them to the cost of the
goods sold first. LIFO is now not allowed in Canada under IFRS or ASPE, but it is still used in
the United States. Although this method resulted in the most precise matching on the income
statement, tax authorities criticized it as way to reduce taxes during periods of inflation. As
well, it was more easily manipulated by management and did not result in accurate valuations
on the balance sheet. Canadian companies that are allowed to report under US GAAP may
still use this method, but it is not allowed for tax purposes in Canada.
7.3.3 The Problem of Overvaluation
Overvaluation can occur when inventory is reported at a higher value than the ultimate amount
that can be recovered. This happens with changes in market conditions or consumer tastes,
or it happens for other reasons. If a particular product loses favour with the market and must
be severely discounted or even disposed of, it would not be appropriate to continue to carry
that item on the balance sheet at its cost when that cost is not recoverable. To avoid this
problem, the lower of cost and net realizable value (LCNRV) needs to be applied. Under this
approach, inventory values are reduced to their recoverable amounts in order to ensure that
current assets are not stated at an amount greater than the ultimate amount of cash that will
be realized from their sale. This also results in recording an expense equal to the loss in value
of the asset, which achieves the effect of matching the cost to the period in which the loss
actually occurs. For example, if an inventory item has a reported cost of $1,000 but a net
realizable value of only $800, the company should record the following journal entry:
General Journal
Loss due to decline in inventory value . . . . . . . . . 200
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Most companies will simply report the loss as part of the cost of goods sold account on
the income statement. Separate disclosure may be appropriate, however, if the amount is
considered material or unusual in nature.
What Is Net Realizable Value?
When determining the loss in inventory value, it is important to have a clear understanding of
the concept of net realizable value (NRV). Net realizable value is an estimate based on the
expected selling price of the goods in the ordinary course of business, less any estimated costs
required to complete and sell the goods. It thus represents the net cash flow that will ultimately
be generated by the sale of the product. Because the net realizable value is an estimate, it can
be affected by management estimation bias and by changes in economic circumstances. As a
result, write-downs of inventories need to be reviewed carefully and frequently by accountants
to ensure the reported amounts are reasonable.
How Is the Lower of Cost and Net Realizable Test Applied?
In general, the lower of cost and net realizable test should be applied to the most detailed
level possible. This would normally be considered to be individual inventory items. However,
in some situations, it may be appropriate to group inventory items together and apply the test
at the group level. This would be appropriate only when items relate to the same product line,
have similar end uses, are produced and marketed in the same geographic area, and cannot
be segregated from other items in the product line in a reasonable or cost-effective way. If
grouping is appropriate, the amount of inventory write-downs will be less than if the test is
applied on an individual-item basis. This occurs because grouping allows for some offsetting
of over- and undervalued items.
Biological Assets
One interesting exception to the lower of cost and net realizable value rule is accounting
for biological assets. Although ASPE does not specifically address these types of assets,
IFRS does present a separate standard: IAS 41 Agriculture. This standard covers raising and
harvesting living plants and animals. The biological assets are considered the original source
of the commercial activity, such as the fruit tree that produces apples, the sheep that produces
wool, or the dairy cow that produces milk. The detailed accounting for these specialized assets
goes beyond the scope of this course. Generally, the product of the biological asset would fall
under the normal rules for inventory accounting, but the biological asset itself is accounted
for at its fair value, less selling costs. This means that every year, the value of the biological-
asset must be determined, and an adjustment to the assets carrying value must be made.
This adjustment would result in an unrealized gain or loss. As the inventory is produced, it is
transferred from the biological-asset account to an inventory account at its fair value less selling
costs at the point of harvest. This value now becomes the inventory’s cost. When inventory is
sold, the sale amount is transferred from the unrealized account to realized revenue.
Conceptually, these types of assets are similar in nature to a capital asset, but they are
also different in that they grow and obtain value independent of the inventory they produce.
This unique nature is the reason IFRS presents a separate standard for the accounting and
disclosure of biological assets.
266 Inventory
7.4 Presentation and Disclosure
Inventories are required to be disclosed as a separate item on the company’s balance sheet.
As well, significant categories of inventories should be disclosed, such as raw materials, work
in process, and finished goods. As with any significant balance sheet item, the company’s
accounting policies for measuring and reporting inventories, including its chosen cost formula,
should be disclosed. The company should also disclose the amount of inventories recognized
as an expense during the period. This would normally be disclosed as cost of goods sold, but
there may be other material amounts that could be disclosed separately, such as write-downs
due to obsolescence and subsequent reversals of those write-downs. As well, under IFRS,
additional details of the write-downs need to be disclosed, such as qualitative reasons for the
write-downs or subsequent reversal. If the inventory has been pledged as collateral for any
outstanding debt, this fact needs to be disclosed, along with the amount pledged.
7.5 Inventory Errors
Given the volume of inventory transactions that occur in a merchandising or manufacturing

business and the portable nature of many inventory items, it is inevitable that errors in ac-
counting for those items will occur. It is important to understand how inventory errors affect
the reported net income and financial position of the company, as these errors could be
material and could affect users’ interpretations of financial results. To understand the effects
of inventory errors, it is useful to review the formula for determining the cost of goods sold:
Opening inventory
+ Purchases
= Goods available for sale
– Ending inventory
= Cost of goods sold
As the ending inventory for one accounting period becomes the opening inventory for the next
period, it is easy to see how an inventory error can affect two accounting periods. Let’s look at
a few examples to determine the effects of different types of inventory errors.
Example 1: Using our previous company, assume PartsPeople missed counting a box of
rotors during the year-end inventory count on December 31, 2019, because the box was
hidden in a storage room. Further assume that the cost of these rotors was $7,000 and that
the invoice for the purchase was correctly recorded. How would this error have affected the
financial statements? If we consider the cost of goods sold formula above, we can see that
understating ending inventory would have overstated the cost of goods sold, as the ending
inventory is subtracted in the formula. As well, consider the following year. The opening
7.5. Inventory Errors 267
inventory on January 1, 2020, would have also been understated, which would have resulted
in an understatement of cost of goods sold for 2020. Thus, over a two-year period, net income
would have been understated by $7,000 in 2019 and overstated by $7,000 in 2020. At the
end of two years, the error would have corrected itself, and the total income reported for those
two years would be correct. However, the allocation of income between the two years was
incorrect, and the company’s balance sheet at December 31, 2019, would have been incorrect.
This could be significant if, for example, PartsPeople had a bank loan with a covenant condition
that required maintenance of certain ratios, such as debt to equity or current ratios. If the error
were discovered prior to the closing of the 2019 books, it would have been corrected as follows:
General Journal
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . 7,000
If the error was not discovered until after the 2019 books were closed, it would have been
corrected as follows:
General Journal
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000
After 2020, as noted above, the error would have corrected itself, so no adjustment would
be required. However, the 2019 financial statements used for comparative purposes in future
years would have to be restated to reflect the correct amounts of inventory and cost of goods
sold.
Example 2: Suppose instead that PartsPeople correctly counted its inventory on December
31, 2019, but missed recording an invoice to purchase a $4,000 shipment of brake pads,
because the invoice fell behind a desk in the accounting office. Again, using our cost of goods
sold formula, we can see that an understatement of purchases will result in an understatement
of the cost of goods sold. As the ending inventory balance was counted correctly, one may
think that this problem was isolated to this year only. However, in 2020, the vendor may have
issued a replacement invoice when they realized PartsPeople hadn’t paid for the shipment.
When PartsPeople recorded the invoice in 2020, the purchases for that year would have been
overstated, which means the cost of goods sold was also overstated. Again, the error corrected
itself over two years, but the allocation of income between the two years was incorrect. If the
error was discovered before the books were closed for 2019 (and before a replacement invoice
is issued by the vendor), it would have been corrected as follows:
General Journal
268 Inventory
If the error was not discovered until after the 2019 books were closed, it would have been
General Journal
Example 3: This time, let’s consider the effect of two errors. Assume PartsPeople sold goods to
a customer with terms FOB shipping on December 29, 2019. The company correctly recorded
this as a sale on December 29, but due to a data-processing error, the goods, with a cost of
$900, were not removed from inventory. Further, assume that a supplier sent a shipment to
PartsPeople on December 29, also with the terms FOB shipping, and the cost of these goods
was $500. These goods were not received until January 4 of the following year, but due to poor
cut-off procedures at PartsPeople, these goods were not included in the year-end inventory
balance.
In this situation, we have two different errors that create opposing effects on the income
statement and balance sheet. The goods sold to the customer should not have been included
in inventory, resulting in an overstatement of year-end inventory. The goods shipped by the
supplier should have been included in inventory, resulting in an understatement of year-end
inventory. The net effect of the two errors is a $900 − $500 = $400 overstatement of
ending inventory. This will result in an understatement of the cost of goods sold and thus
an overstatement of net income. If these errors were discovered before the books were closed
in 2019, the entry to correct them would be as follows:
General Journal
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
If the errors were not discovered until after the 2019 books were closed, they would have been
General Journal
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
These three illustrations are just a small sample of the many kinds of inventory errors that can
occur. In evaluating the effect of inventory errors, it is important to have a clear understanding
of the nature of the error and its impact on the cost of goods sold formula. It is also important
to consider the effect of the error on subsequent years. Although immediate correction of
errors is preferable, most inventory errors will correct themselves over a two-year period.
7.6. Estimating Inventory 269
However, even if an error corrects itself, there may still be a need to restate comparative
financial-statement information.
7.6 Estimating Inventory
Although a business will normally take an inventory count at least once per year to verify the
perpetual inventory records, there may be circumstances where an inventory count is either
impractical or impossible. For example, when a company prepares interim unaudited financial
statements, it may be too costly to conduct an inventory count, as operations would have
to cease during the count, and staff would need to be reallocated to this purpose. Or, in
the case where a disaster strikes, such as a warehouse fire, inventory may be destroyed,
making a count impossible. In these situations, the company may choose to use an estimation
method to determine the inventory. The estimated balance can be used for the interim financial
statements or for making an insurance claim in the case of a disaster. Several methods can
be used to estimate inventory. We will focus on the gross profit method.
This method attempts to estimate the inventory balance at a point in time using past rela-
tionships between the cost of goods sold and sales and then applying the cost of goods
sold formula to determine the ending inventory balance. Consider the following scenario for
PartsPeople. On May 17, 2019, a fire caused by faulty electrical wiring completely destroyed
one of the company’s warehouses and all of the contents. Fortunately, this loss was covered by
the company’s insurance policy, but in order to make a claim, the company needed a credible
estimate of the amount of inventory destroyed. Assume that the inventory on January 1, 2019,
was reported at a cost of $250,000, which was verified by a count. As well, assume that
between January 1 and May 17, 2019, the cost of all inventory purchases was $820,000, and
sales for this period were reported at $1,200,000. Based on analysis of the previous year’s
results, the company knows that its gross profit percentage is 25 percent. Based on this
information, the company could have estimated the cost of the destroyed inventory as follows:
Inventory on January 1 $250,000

Purchases $820,000
Goods available for sale $1,070,000
Sales $1,200,000
Less gross profit (25% × $1,200,000) $300,000
Estimated cost of goods sold $900,000
Estimated inventory on May 17 $170,000
PartsPeople could have used this information to make a claim in the amount of $170,000 for
inventory damaged in the fire. There are some obvious limitations in using this technique.
270 Inventory
First, the gross profit percentage used here was based on the previous year’s results. If the
company had made changes to its pricing or purchasing strategies in 2019, the percentage
would need to have been adjusted. Second, a single gross profit percentage has been used for
all inventory items. It is quite likely that individual inventory items would have different amounts
of gross profit built into their pricing, depending on consumer demand, purchasing dynamics,
and so on. This blanket rate is based on an average of all inventory items, but depending on
the product mix of both sales and purchases during the intervening period, this rate may not
be appropriate.
Because this technique provides only an estimate, it should not be used for annual financial
reporting purposes. In the circumstances noted above, however, it can be useful, but the
calculated amount should be compared with the perpetual inventory records to determine the
reasonableness of the estimate. Management should consider the suitability of the single
gross profit percentage and consider any adjustments that may be appropriate.
7.7 Inventory Analysis
As mentioned previously, inventory can be a significant asset for many businesses, as it

represents profit-generating potential. Buying or producing goods at a certain price and then
selling them for a higher price is the essence of the retail, wholesale and manufacturing
sectors. Obviously, efficient management of these inventories is essential for the success
of the business. A company needs to control the cost of inventories in order to maintain its
profit margins. As well, companies need to ensure that inventories move through the system
quickly. Inventories sitting in a warehouse, unsold, are not producing profits or cash flow
for the company. While the items sit in the warehouse, the company will incur costs: the
cost of the warehouse space itself and the cost of funds required to finance the inventory.
Obviously, to minimize these costs, it is important to sell the inventory as quickly as possible,
while maintaining the desired margin.
To analyze inventory, we will look at two types of ratios: gross profit margin and inventory
turnover period.
Gross Profit Margin
Gross profit represents the difference between sales revenue and cost of sales. This is an
essential measurement in determining the profitability of a business, as it represents the profit
7.7. Inventory Analysis 271
generated by the primary business activity of selling goods, before considering any other
expenses. To facilitate comparisons between different sales volumes, the gross profit margin
is calculated as follows:
Gross profit
Gross profit margin = × 100
Sales revenue
By expressing this relationship as a percentage, one can make comparisons between dif-
ferent companies or different accounting periods for the same company. This is a type of
common size analysis that helps the reader discern relationships and trends that may indicate
something about the company’s profitability. Consider the following example from the financial
statements of a large automobile manufacturer (in $ millions):
Year Ended Year Ended

December 31, 2021 December 31, 2020
Sales $ 136,200 $ 140,100
Cost of sales 123,400 125,300
Gross profit $ 12,800 $ 14,800
Sales declined slightly in 2021 compared with the previous year, as did gross profit. By
calculating the gross profit margin, we can get a better idea of the meaning of these results:
Gross profit margin 2021 = 9.40%

Gross profit margin 2020 = 10.56%
Although the gross profit margin dropped by only 1.16 percent between years, this represents
lost profits of approximately $1.5 billion on this scale of revenues. Management would obvi-
ously be motivated to find ways to control these margins to prevent further declines, whether
through adjusting sales prices or controlling costs better.
Inventory Turnover Period
Aside from the profitability of the business’s core activities as calculated above, management
is also interested in the efficiency of carrying out those activities. One way to measure the
efficiency of inventory movements to calculate the inventory turnover period:
Average inventories held

Inventory turnover period = × 365
Cost of sales
This ratio will help us understand how quickly the company moves inventory through the
various business processes that eventually result in a sale. For a manufacturing company,
272 Inventory
this process begins with the receipt of raw materials and ends when the finished goods are
finally sold. Once again, consider the reported inventory levels of the automobile manufacturer
(in $ millions): 2021–$7,860, 2020–$7,700, 2019–$7,360.
Using the formula above, we can determine the following inventory turnover periods:
2021: 23.01 days

2020: 21.94 days
(Note that the average inventories amount was calculated as the simple average of opening
and closing inventories. For businesses with seasonal or other unusual patterns of sales, more
sophisticated calculations of the average inventories may be required.)
In this example, the inventory turnover period increased by slightly more than one day during
the current year. This may not seem significant, but it does indicate that inventories are
being held for a longer time, which will increase the company’s costs. Line managers are
very motivated to find ways to reduce the turnover period through more efficient purchasing
practices, better production techniques, and more effective sales promotions.
It should be noted that the absolute values of the ratios we have calculated are not particularly
useful on their own. Like all ratios, a comparison or benchmark is needed for comparison.
Most companies will start by comparing the ratio with the previous year to see if improvements
have occurred in the current year. Many managers will also compare with a budgeted or target
amount, as this will provide feedback on the actions they have taken. It may also be useful
to compare with industry standards or competitor data, as this indicates something of the
company’s competitive position. Ratio analysis does not provide answers to questions, but it
does help managers and other financial statement users to identify areas where performance
is improving or declining.
IFRS ASPE
Biological assets that produce a harvestable No specific standard exists for biological
product are accounted for under the provi- assets or agricultural produce.
sions of IAS 41.
Disclosures regarding categories of invento- Disclosures regarding categories of inven-
ries and accounting policies are required. As tories and accounting policies used are
well, further disclosures regarding qualitative required.
reasons for write-downs are required.
Chapter Summary 273
Chapter Summary
LO 1 Define inventory, and identify those characteristics that distinguish it from

other assets.
Inventories can be a significant asset for many businesses. The key feature of inventory is
that it is held for sale in the normal course of business, which distinguishes it from financial
instruments and long-lived assets, such as property, plant, and equipment.
LO 2: Identify the types of costs that should be included in inventory.
Recognition of the initial cost of purchase should include transportation, discounts, and other
nonrecoverable taxes and fees that need to be paid to transport the goods to the place of
business. FOB terms of purchase need to be considered when applying cut-off procedures
at the end of the accounting period. This is important for determining when the responsibility
for the inventory passes from the seller to the buyer. For manufacturers, conversion costs
must also be included in inventory. For direct materials and labour, this allocation is fairly
straightforward. However certain issues with overhead allocations can occur with low or high
production levels. With abnormally low production levels, overheads should be allocated at
the rate used for normal production levels. With abnormally high production levels, overheads
should be allocated using the actual level of production. Other costs required to bring the
inventory to the place of business and get into a saleable condition may also be included. The
accountant will need to exercise judgment when considering other costs to include.
LO 3: Identify accounting issues and treatments applied to inventory subsequent

to its purchase.
LO 3.1: Describe the differences between periodic and perpetual inventory systems.
Perpetual inventory systems are those that instantly update accounting records for sales and
purchases of goods. These types of systems are commonly used today and are facilitated by
advances in computer and other technologies. Periodic inventory systems do not allow for the
real-time updating of accounting records. Rather, these systems require a periodic inventory
count (at least annually) that is then used to derive the cost of goods sold. These types of
systems are less useful for management purposes. Even under a perpetual inventory sys-
tem, annual inventory counts are still required to detect spoilage, theft, or other unaccounted
inventory changes.
274 Inventory
LO 3.2: Identify the appropriate criteria for selection of a cost flow formula, and apply
different cost flow formulas to inventory transactions.
The cost flow formula determines how to allocate inventory costs between the income state-
ment and the balance sheet. Although specific identification of individual inventory items is
the most precise way to allocate these costs, this method would only be appropriate with
inventory items whose characteristics uniquely differentiate them from other inventory units.
For homogeneous inventory products, weighted average or first in, first out (FIFO) are appro-
priate choices. Weighted average (or moving average, when used with a perpetual inventory
system) recalculates the average cost of the inventory every time a new purchase is made.
This revised cost is used to determine the cost of goods sold. With FIFO, the oldest inventory
items are assumed to be sold first. Each method has certain advantages and disadvantages,
and each has a different effect on the balance sheet and income statement. The choice of
method will depend on the actual physical movement of goods, financial reporting objectives,
tax considerations, and other factors. Whatever method is chosen, it should be applied
consistently.
LO 3.3: Determine when inventories are overvalued, and apply the lower of cost and net
realizable value rule to write-down those inventories.
When economic circumstances change, such as a shift in consumer preferences, a company

may find itself holding inventory that cannot be sold for its carrying value. In this case, the
inventory should be written-down to its net realizable value (selling price less estimated costs
required to complete and sell the goods) in order to ensure the balance sheet is not reporting
a current asset at a value greater than the amount of cash that can be realized from its sale.
Generally, this technique should be applied on an individual-item basis, but in certain cases
where a group of products all belong to one product line, are produced and marketed in one
geographic area, have similar end uses, or are difficult to segregate, it may be appropriate to
apply the test on a grouped basis. Judgment is required in applying this technique, as net
realizable values are estimates that may not be easy to verify.
One unique application of fair value inventory accounting relates to biological assets. These
are assets that are living plants or animals used to produce an agricultural product. Under
IFRS these assets are adjusted to their fair value, less selling costs, each year. This can result
in increases as well as decreases in value.
LO 4: Describe the presentation and disclosure requirements for inventories

under both IFRS and ASPE.
Inventory should be described separately on the balance sheet, with separate disclosure of
major categories such as raw materials, work in process, and finished goods. Accounting
policies used should also be disclosed, as well as the amount of any inventory that has been
Chapter Summary 275
pledged as collateral for any liability. The amount of inventory expensed during the period
should be disclosed as cost of goods sold on the income statement, but other categories, if
material, could be disclosed separately, such as significant write-downs or reversals of write-
downs.
LO 5: Identify the effects of inventory errors on both the balance sheet and
income statement, and prepare appropriate adjustments to correct the errors.
Due to the nature and relative volume of inventory transactions, material errors in financial
reporting can occur. To correct these errors, the accountant must have a firm understanding
of the cost of goods sold formula and its effects on both the current and subsequent years.
If inventory errors are discovered after the closing of the books, an adjustment to retained
earnings may be required. If an error is not discovered until two years after its occurrence,
it is quite likely that the error has corrected itself. In this case, no adjusting entry would be
required, but restatement of prior-year comparative results would still be necessary.
LO 6: Calculate estimated inventory amounts using the gross profit method.
The gross profit method can be useful for estimating inventory amounts when a physical count
is impractical or impossible. This could be the case when for interim reporting periods or when
the inventory is destroyed in a disaster. The technique uses past gross profit percentages
and applies it to purchases and sales during the period to estimate the amount of inventory
on hand. The method is not appropriate for annual financial reporting purposes, as the
estimate could be subject to error as a result of using past gross profit percentages that are
not representative of current margins or are not representative of the current product mix.
Considerable judgment and care should be applied when using this method.
LO 7: Calculate gross profit margin and inventory turnover period, and evaluate
the significance of these results with respect to the profitability and efficiency of
the business’s operations.
Managers are concerned about the profitability of the company’s core business of buying
and selling products. Managers are also concerned with the efficiency with which products
are moved through the production and sales process. Calculating gross profit margin can
identify trends in the profitability of the company’s core operations. Calculating inventory
turnover period can identify problems with the efficiency movement of inventories, including
raw materials, work in progress, and finished goods. Ratio calculations need to be compared
with some type of benchmark to be meaningful.
276 Inventory
LO 8: Identify differences in accounting for inventories between ASPE and IFRS.
Inventory accounting standards under IFRS and ASPE are substantially the same. The pri-
mary difference relates to biological assets. IFRS has a complete set of standards (IAS 41)
for these types of assets, whereas ASPE does not separately identify this category. As well,
IFRS requires certain additional disclosures that ASPE does not, including a description of
qualitative reasons for inventory write-ups and write-downs.
References
BlackBerry Ltd. (2014). 1.3 Management’s discussion and analysis of financial condition
and results of operations for the fiscal year ended March 1, 2014. In Blackberry Ltd. Annual
Report. Retrieved from http://us.blackberry.com/content/dam/bbCompany/Desktop/G
lobal/PDF/Investors/Documents/2014/Q4_FY14_Filing.pdf
Damouni, N., Kim, S., & Leske, N. (2013, October 4). Cisco, Google, SAP discussing Black-
Berry bids.Reuters.com. Retrieved from
http://www.reuters.com/article/us-blackberry-buyers-idUSBRE99400220131005
International Accounting Standards. (n.d.). In IAS Plus. Retrieved from http://www.iasplus

.com/en/standards/ias
Exercises
EXERCISE 7–1
Identify which of the following costs of a product manufacturer would be included in inventories:
• Salaries of assembly line workers
• Raw materials
• Salary of factory foreman
• Heating cost for the factory
• Miscellaneous supplies used in production process
• Salary of the CEO
• Costs to ship raw materials from the supplier to the factory

Exercises 277
• Electricity cost for the factory
• Salaries of the sales team
• Depreciation of factory machines
• Property taxes on factory building
• Discounts for early payment of raw material purchases
• Salaries of the factory’s janitorial staff
EXERCISE 7–2
Complete the following table by identifying whether the seller (S) or the purchaser (P) is the
appropriate response for each cell.
FOB Shipping FOB Destination

Owns the goods while in transit
Is responsible for the loss if goods are damaged in
transit
Pays for the shipping costs
EXERCISE 7–3
Hasselbacher Industries Ltd. has fixed production overhead costs of $150,000. In a normal
year, the company produces 100,000 units of product, which results in a fixed overhead
allocation of $1.50 per unit.
Required:
a. If the company produces 105,000 units in a year, how much total fixed overhead should
be allocated to the inventory produced?
b. If the company produces 30,000 units in a year, how much total fixed overhead should
c. If the company produces 160,000 units in a year, how much total fixed overhead should
EXERCISE 7–4
278 Inventory
Segura Ltd. operates a small retail store that sells guitars and other musical accessories.
During the month of May, the following transactions occurred:
Number of Units Cost per unit

Opening inventory, May 1 8 $550
Purchase, May 5 50 $560
Sale, May 15 15
Sale, May 25 23
Closing inventory, May 31 42
Required: Segura Ltd. uses a perpetual inventory system. Using the FIFO cost flow assump-
tion, calculate the cost of goods sold for the month of May and inventory balance on May
31.
EXERCISE 7–5
Refer to the information in the previous question.
Required: Assume that Segura Ltd. uses the moving average cost flow assumption instead.
Calculate the cost of goods sold for the month of May and the inventory balance on May 31.
EXERCISE 7–6
The following chart for Severn Ltd. details the cost and selling price of the company’s inventory:
Description Category Cost ($) Selling

Price ($)
Brake pad #1 Brake pads 159 140
Total brake pads 334 320
Soft tire Tires 325 337

Hard tire Tires 312 303
Total tires 637 640
Required:
a. Assume that grouping of inventory items is not appropriate in this case. Apply the lower
of cost and net realizable value test and provide the required adjusting journal entry.
Exercises 279
b. Assume that grouping of inventory items is appropriate in this case. Apply the lower of
cost and net realizable value test and provide the required adjusting journal entry.
EXERCISE 7–7
Hawthorne Inc. identified the following inventory errors in 2020.
a. Goods were in transit from a vendor on December 31, 2020. The invoice cost was
$82,000 and the goods were shipped FOB shipping point on December 27, 2020. The
goods will be sold in 2021 for $135,000. The goods were not included in the inventory
count.
b. On January 6, 2021, a freight bill for $6,000 was received. The bill relates to merchandise
purchased in December 2020 and two-thirds of this merchandise was still in inventory
on December 31, 2020. The freight charges were not included in either the inventory
account or accounts payable on December 31, 2020.
c. Goods shipped to a customer FOB destination on December 29, 2020, were in transit
on December 31, 2020, and had a cost of $27,000. When notified that the customer had
received the goods on January 3, 2021, Hawthorne’s bookkeeper issued a sales invoice
for $42,000. These goods were not included in the inventory count.
d. Excluded from inventory was a box labelled “Return for Credit.” The cost of this merchan-
dise was $2,000 and the sale price to a customer had been $3,500. No entry had been
made to record this return and none of the returned merchandise seemed damaged.
Required: Determine the effect of each of the above errors on both the balance sheet accounts
at December 31, 2020, and the reported net income for the year ended December 31, 2020
and complete the table below.
Item Inventory A/R A/P Net Income

A
B
C
D
Total
EXERCISE 7–8
Refer to the information provided in the previous question.
Required:
280 Inventory
a. Assume the books are still open for 2020. Provide any required adjusting journal entries
to correct the errors.
b. How would the adjustments change if the books are now closed for 2020?
EXERCISE 7–9
Wormold Industries suffered a fire in its warehouse on March 4, 2021. The warehouse was full
of finished goods, and after reviewing the damage, management determined that inventory,
with a retail selling price of $90,000, was not damaged by the fire.
For the period from January 1, 2021, to March 4, 2021, accounting records showed the
following:
Purchases $650,000
Purchase returns 16,000
Sales revenue 955,000
The inventory balance on January 1, 2021, was $275,000, and the company has historically
earned a gross profit percentage of 35%.
Required: Use the gross profit method to determine the cost of inventory damaged by the fire.
EXERCISE 7–10
Bollen Custom Automobile Mfg. reported the following results (all amounts are in millions
USD):
2020 2019
Sales 20,222 13,972
Cost of sales 17,164 11,141
Gross profit 3,058 2,831
Inventories at year end 2,982 1,564
Inventories at the end of 2018 were $1,239.
Required: Using the data above, analyze the profitability and efficiency of the company with
respect to its core business activities. Provide any points for further investigation that your
analysis reveals.
Chapter 8
Intercorporate Investments
An Acquisition Debacle for Hewlett Packard
In 2011, Hewlett-Packard (HP) purchased approximately 87% of the share capital (213
million shares) of Autonomy Corporation plc. for US $11.1 billion cash. The purpose of
this acquisition was to ensure that HP took the lead in the quickly growing enterprise
information management sector. Autonomy’s products and solutions complemented HP’s
existing enterprise offerings and strengthened the company’s data analytics, cloud, indus-
try, and workflow management capabilities, so the acquisition made sense from a strategic
point of view.
Autonomy HP was to operate as a separate business unit. Dr. Mike Lynch, founder and
CEO of Autonomy, would continue to lead Autonomy HP’s business and report to HP’s
Chief Executive Meg Whitman (Hewlett Packard, 2011).
However, trouble quickly brewed and in 2012, accounting “anomalies” were uncovered by
HP, giving rise to a massive impairment write-down of the Autonomy HP unit to the tune of
an $8.8 billion impairment charge. Compared to the original $11.1 billion purchase price,
the impairment represented a whopping 79% drop in the investment’s value, a mere one
year later.
HP alleged that the owners of Autonomy misrepresented their company’s financial position
due to what HP referred to as serious accounting improprieties. To make matters worse,
all this came at a bad time for HP, given that its fourth quarter financial results were already
down 20% in hardware sales and 12% in laptop/desktop sales (Souppouris, 2012).
The question remained; how was it possible to lose 79% of Autonomy HP unit value in less
than one year? HP claims to have discovered all kinds of accounting irregularities which
were denied by Autonomy’s founder and CEO, Mike Lynch. HP claimed that it would have
paid half the purchase price, had it known what it later discovered about Autonomy’s true
profitability and growth.
Consider that software companies like Autonomy do not have much value in hard assets,
so the impairment did not relate to a revaluation of assets. Also, Autonomy did not have
much in the way of outstanding invoices, so there was no large non-payment of amounts
owed to trigger the drop in value and subsequent impairment write-down.
So the impairment charge more likely reflected a reassessment by HP of the future cash
flows originally estimated, based on the financials, to be much less than anticipated. This
281
282 Intercorporate Investments
is backed up by Chief Executive Meg Whitman’s assertion that Autonomy’s real operating
profit margin was closer to 30%, and not its reported 40 to 45%.
Whitman accused Autonomy of recording both long-term deals and sales through resellers
as fully realized sales. Consider that the booking of revenue is not clear-cut in the software
industry because of the differing accounting rules. For example, if Autonomy recorded an
extra $20 million of future sales now, without recording the associated additional cost of
goods sold, the gross profit percentage would exponentially increase, perhaps by as much
as 10 to 15%.
HP also stated that the actual losses of Autonomy’s loss-prone hardware division were
misclassified as “sales and marketing expenses” in the operating expenses section rather
than as cost of goods sold in the gross profit section. Since sales figures were reported as
steeply increasing, this would create a more favourable overall growth rate. Since growth
is another factor in business valuations, this exponential effect could also have affected
the purchase price HP thought it was willing to pay.
Companies can also increase reported net income by inappropriately classifying certain
current expenses as investments (assets), which are thereafter amortized over several
years. Some analysts suspected that Autonomy misclassified some of its research costs in
this way. Moreover, some of Autonomy’s growth was generated from acquisitions of other
businesses. Takeovers can, for example, give a more favourable impression of growth
rates, if pre-acquisition sales are understated. In this light, apparently, some analysts
questioned Autonomy’s acquisition accounting.
With all the factors discussed above, it is possible that HP could allege and demonstrate
that inappropriate reporting and valuation errors led to a discrepancy the size of which it
purports. Autonomy HP unit CEO, Mike Lynch, denies all charges of reporting impropriety
or error. He said that Autonomy followed international accounting rules.
Until HP’s accusations are fully investigated, it will be impossible for stakeholders and
others to know what really happened.
(Source: Webb, 2012)
[Note: IFRS refers to the balance sheet as the statement of financial position (SFP) and ASPE
continues to use the historically-used term balance sheet (BS). To simplify the terminology,
this chapter will refer to this statement as the historically generic term balance sheet.
Chapter 8 Learning Objectives 283
LO 1: Describe intercorporate investments and their role in accounting and business.
LO 2: Identify and describe the three types of non-strategic investments.
LO 2.1: Fair value through net income (FVNI) classification and accounting treatment.
LO 2.2: Fair value through OCI (FVOCI) classification and accounting treatment.
LO 2.3: Amortized Cost (AC) classification and accounting treatment.
LO 3: Identify and describe the three types of strategic investments.
LO 3.1: Investments in associates classification and accounting treatment.

LO 3.2: Investments in subsidiaries classification and accounting treatment.
LO 3.3: Investments in joint arrangements general overview.
LO 4: Explain disclosures requirements for intercorporate investments.
LO 5: Identify the issues for stakeholders regarding investment analyses of performance.
LO 6: Discuss the similarities and differences between IFRS and ASPE for the three non-
strategic investment classifications.
Introduction
Intercorporate investments arise when companies invest in other companies’ securities as the
Hewlett Packard shares acquisition cover story illustrates. This chapter will focus on explaining
how these investments are classified, measured (both initially and subsequently), reported,
and analyzed. Canada currently has two IFRS standards in effect: IFRS 9, which was effective
January 1, 2018 and ASPE. The purpose of this chapter is to identify the various classifications
and accounting treatments permitted by either standard for investments in other companies’
debt and equity securities.
1.0 Intercorporate
Investments: Overview Fair value net
income (FVNI)
2.0 Non-Strategic Fair value OCI (FVOCI)

Investments
Amortized cost (AC)

Intercorporate
Investments
Associate (Significant
Influence)
Subsidiary
3.0 Strategic Investments
(Control)
4.0 Disclosures Joint Arrangements
5.0 Analysis
6.0 IFRS/ASPE
Key Differences
8.1 Intercorporate Investments: Overview
There are many reasons why companies invest in bonds, shares, and securities of other
companies. It is well-known that banks, insurance companies, and other financial institutions
hold large portfolios of investments (financed by deposits and fees their customers paid to the
banks) to increase their interest income. But it may also be the best way for companies in
non-financial industry sectors to utilize excess cash and to strengthen relationships with other
companies. If the investments can earn a higher return compared to idle cash sitting in a
bank account, then it may be in a company’s best interests to invest. The returns from these
investments will be in the form of interest income, dividend income, or an appreciation in the
value of the investment itself, such as the market price of a share.
In some cases, investments are a part of a portfolio of actively managed short-term invest-
ments undertaken in the normal course of business, to offset other financial risks such as
foreign exchange fluctuations. Other portfolios may be for longer-term investments such as
bonds that will increase the company’s interest income. These are examples of non-strategic
8.1. Intercorporate Investments: Overview 285
investments where the prime reason for investing is to increase company income using cash
not required for normal business operations.
Alternatively, companies may undertake strategic investments where the prime reason is to
enhance a company’s operations. If the percentage of voting shares held as an investment is
large enough, the investing company can exercise its right to influence or control the investee
company’s investing, financing and operating decisions. Strategies to purchase shares of a
manufacturer, wholesaler, or customer company can strengthen those relationships, perhaps
to guarantee a source of raw materials or increase market share for sales. In some cases,
it can be part of a strategy to take over a competitor because it would enhance business
operations and profits to do so. Intercorporate investments do have risks as the opening
story explains. Hewlett Packard’s acquisition of a controlling interest in the voting shares of
Autonomy Corp. is an example of where a strategic investment, which was to improve HP’s
operations and profit, does not always work out as originally intended.
The many different reasons why companies invest in other companies creates significant
accounting and disclosure challenges for standard setters. For example, how are investments
to be classified and reported in order to provide relevant information about the investments to
the stakeholders? What is the best measurement—cost or fair value? How should investments
be reported if the investment’s value were to suddenly decline in the market place? Are
there differences in the accounting treatments and reporting requirements between IFRS and
ASPE? These are all relevant accounting issues that will be examined in this chapter.
What are Investments?
Investments are financial assets. Chapter 6: Cash and Receivables, defines financial assets
as those that have contractual rights to receive cash or other financial assets from another
party. Examples of intercorporate investments include the purchase of another company’s
debt instruments (such as bonds or convertible debt) or equity instruments (such as common
shares, preferred shares, options, rights, and warrants). The company purchasing the invest-
ment (investor) will report these purchases as investment assets, while the company whose
bonds or shares were purchased (investee) will report these as liabilities or equity respectively.
For this reason, intercorporate investments are financial instruments because the financial
asset reported by one company gives rise to a financial liability or equity instrument in another
company.
Initial Measurement
The initial measurement for investments is relatively straightforward. All investments are
initially measured at fair value which is the acquisition price that would normally be agreed
to between unrelated parties. Any transactions costs such as fees and commissions are either
expensed or included in the investment asset except valuation which will be explained later in
the chapter.
Subsequent Measurement
There is no single subsequent measurement for all investments for IFRS and ASPE. Below is
a summary of the various classification alternatives for the two current standards for IFRS 9
and ASPE.
Classification
of Investments
Strategic Investments
Non-Strategic Investments
(voting shares)
Equity Instruments
(less than 20% ownership) Debt Instruments
FVNI – to ***IFRS ONLY FVNI – to ***IFRS ONLY AC – to collect Associate Joint Operation
FVOCI – FVOCI – contractual Subsidiary
realize changes realize changes (Significant (Joint Control)
to collect to collect cash flows (Control) 50% -
in value in value Influence) 20% - various %
contractual cash contractual cash such as interest 100% ownership
through trading through trading 50% ownership ownership
flows and to sell flows and to sell or dividends
*includes most derivatives
As stated above, investments can either be a strategic acquisition of voting shares of another
company in order to influence the investee company’s operating, investing, financing decisions,
or a non-strategic financing decision in order to earn a return on otherwise idle or under-utilized
cash. Within these two broad categories are six classifications: fair value through net income
(FVNI), fair value through OCI (FVOCI), amortized cost (AC), significant influence, subsidiary,
and joint arrangement.
Both IFRS and ASPE identify some percentage of ownership reference points as guidelines
to help determine in which category to classify an investment. For example, any investment in
shares where the ownership is less than 20% would be considered a non-strategic investment.
It is highly unlikely that this level of ownership would result in having any influence on a
company’s decisions or operations. These investments are acquired mainly for the investment
return of interest income, dividend income, and capital appreciation resulting from a change in
fair values of the investment itself, depending on the company’s investment business model.
For share purchases of between 20% and 50%, the investor will more likely have a significant
influence over the investee company as previously explained. These percentages are not cast
in stone. Classifications of investments do not always have to adhere to these ranges where it
can be shown that another classification is a better measure of the true economic substance
of the investment. For example, an investment of 30% of the shares of a company may not
have any significant influence if the remaining 70% is held by very few other investors who are
tightly connected together. The circumstances for each investment must be considered when
determining the classification of an investment purchase.
8.1. Intercorporate Investments: Overview 287
A share investment of 50% or greater will result in the investor having control over the com-
pany’s decisions and policies because the majority of the shares are held by the investing
company. The investee company will be regarded as a subsidiary of the investor company.
This was the case in the cover story where Hewlett Packard purchased the majority of the
outstanding shares of Autonomy Corporation in order to enhance HP’s operations.
Classifications and Accounting Treatments
Below is a classification summary for IFRS 9 and ASPE (Sec. 3856). Note the differences be-
tween the accounting standards. ASPE has two classifications for its non-strategic investments
and IFRS has three classifications. The table below summarizes the classification criteria for
ASPE and IFRS:
ASPE IFRS
Management intent and in-
vestment business model is
Type of investment as either to hold and collect interest
Classification debt or equity, and if there is and dividends only, or to
basis an active market also sell/trade in order to
realize changes in value of
the investment
Description Classification Description Classification
Non-strategic Investments
Short-term Fair value through Equities, debt or Fair value through
trading net income (FVNI) non-hedged net income (FVNI)
Investments: derivatives (i.e.,
equities trading options, warrants)
in an active market where intent is to
sell/trade to realize
changes in value of
the investment
Equities1 and debt Fair value through
where intent is to Other
collect cash flows Comprehensive
of interest or Income (FVOCI)
dividends, AND to with recycling
sell, to realize (debt) or no
changes in value of recycling (equities)
the investment.
All other Equities at cost Debt where intent Amortized cost
equities and and debt at is to collect (AC)
debt amortized cost contractual cash
(AC) flows of principal
and interest and to
hold investment
until maturity
Strategic Investments – must be voting shares
Significant Choice of equity Associate: Equity method

Influence: method, cost or fair equities acquired
equities value through net to influence
income if active company decisions
market exists
Subsidiary: Choice of Control: Consolidation
equities consolidation, equities acquired
equity, cost, or for control of
quoted amount if company
active market
exists
Joint Proportionate Joint Proportionate
Arrangement: consolidation, Arrangement: consolidation or
equities equity, or cost equities equity depending
depending upon upon the nature of
the nature of the the joint
joint arrangement arrangement and
and arrangement arrangement terms
terms
Under IFRS 9, investments are divided into separate portfolios according to the way they are
managed. For non-strategic investments these classifications are based on “held to collect
solely principal and interest cash flows (AC)”, “held to collect solely principal and interest cash
flows AND to sell (FVOCI)”, and “all else (FVNI)”. That is not to say that investments classified
as AC can never be sold, but sales in this classification would be incidental and made in
response to some sort of change in the investment, such as an increase in investment risk.
FVOCI considers that sales are an integral part of portfolio management where active buying
and selling are typical activities in order to collect cash flows while investing is held, AND
to realize increases in fair values through selling. Both ASPE and IFRS allows companies
to classify an investment as FVNI only at acquisition. For IFRS this FVNI election is only
to eliminate or significantly reduce an accounting mismatch arising from a measurement or
recognition inconsistency for investments that would otherwise be classified as AC or FVOCI.
Differences in the ASPE standard, such as the choice of either straight-line or effective in-
terest rate methods or impairment evaluation and measurement of certain investments, will
be separately identified throughout the chapter. Companies that follow IFRS can choose to
record interest, dividends, and fair value adjustments to a single “investment income or loss”
account or they can keep these separated in their own accounts. ASPE requires that interest,
dividends, and fair value adjustments each be reported separately. Since IFRS companies still
need to know the interest expense from any dividends received for tax purposes, this chapter
separates interest and dividends for both IFRS and ASPE companies, as this is appropriate
for both standards and for simplicity and consistency.
Below are the classification categories with details about how they are measured and re-
ported.
1
Equities is a special irrevocable election only.
8.2. Non-Strategic Investments 289
8.2 Non-Strategic Investments
8.2.1 Fair Value Through Net Income (FVNI)
Types of Investments Accounting Treatment

Debt (bonds) Interest and dividends through net income as earned/declared.
Equities2 (shares) Remeasure investment to fair value at each reporting date or
upon sale, with gains/losses through net income. Can be
recorded directly to investment or through an asset valuation
account.
Investments in debt and equity, including derivatives, are reported at their fair value at each
balance sheet date with fair value changes reported in net income. Transactions costs are
expensed as incurred. Any gain (loss) upon sale of the investment is reported in net income.
FVNI investments are reported as a current asset if they meet the conditions of a current
asset, such as; a cash equivalent, are held for trading purposes, or are expected to mature
or be sold within 12 months of the balance sheet/SFP reporting date or the normal operating
cycle. Otherwise, they are a long-term asset.
Market (fair) values can go up or down while FVNI investments are being held. These in-
creases and decreases are referred to as unrealized gains and losses and are reported in
net income. Once a sale occurs, the investment can either be remeasured to its fair value
as an unrealized gain/loss followed by the receipt of cash, or the gain or loss will be recorded
as realized and reported through net income as a gain (loss) from the sale of the investment.
Either treatment is acceptable for FVNI classification, because the unrealized and realized
gains/losses are reported the same way in the income statement. For this reason, treatment
as either an unrealized or realized gain/loss upon sales can become blurred.
In order to preserve the original cost of the investment, companies may choose to use an asset
valuation allowance account instead of directly changing the asset carrying value. This is an
option for any of the FVNI, FVOCI, and AC classification discussed in this chapter and will be
illustrated in more detail below.
Impairment
Investments are reported at fair value at each reporting date, so no separate impairment
evaluations and entries are required.
2
Equities in FVNI classification can include non-hedged derivatives such as options or warrants.
FVNI Investments in Shares
The accounting for FVNI equity investments such as shares is usually more straight-forward
compared to debt investments such as bonds.
Assume that the following equity transactions occurred for Lornelund Ltd. in 2020:
Lornelund Ltd. – Non-Strategic Equity Investments

Dates # of Price per Total
in 2020 Transaction Detail Shares Share Amount
June 1 Purchased Symec Org. shares for $150 per share (transaction 1,000 $150.00 $150,000
costs were an additional $1.25 per share)
Aug 15 Purchased Hemiota Ltd. shares 2,500 84.00 210,000
Nov 30 Dividends for Symec declared and received 1,000 6.10 6,100
Dec 31 Market price for Symec shares at year-end 165.00
Dec 31 Market price for Hemiota shares at year-end 82.00
Dates
in 2021
Jan 10 Sold Symec shares 500 165.70 82,850
The journal entries for the FVNI investments are recorded below:
General Journal
Jun 1 2020 FVNI investments – Symec shares . . . . . . . . . . . . 150,000
Transactions fees expense . . . . . . . . . . . . . . . . . . . . 1,250
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151,250
Aug 15 2020 FVNI investments – Hemiota shares . . . . . . . . . . . 210,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210,000
Nov 30 2020 Cash (or Dividend receivable if declared but not 6,100
paid) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Dividend income . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,100
Dec 31 2020 FVNI investments – Symec shares . . . . . . . . . . . . 15,000

Unrealized gain (loss) on FVNI investments 15,000
($165 − $150) × 1,000
Dec 31 2020 Unrealized gain (loss) on FVNI investments. . . . 5,000

FVNI investments – Hemiota shares . . . . . . . 5,000
($82 − 84) × 2,500
Jan 10 2021 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82,850

FVNI investments – Symec shares . . . . . . . . . 82,500
Gain (loss) on sale of FVNI investments . . . . 350
For cash amount: ($165.70 × 500 shares), for
share value: ($165 × 500 shares)
Note that the transaction fees are expensed for FVNI investments. This makes intuitive sense
since the shares are being purchased at their fair market value and this represents the max-
imum amount that can be reported on the investor company’s balance sheet. At December
31 year-end, Lornelund makes two adjusting entries to record the latest fair values changes
for each FVNI investment. The fair value for Symec shares increased from $150 to $165 per
share, resulting in an overall increase in the investment value by $15,000 (from $150,000 to
$165,000). Conversely, the fair value for Hemiota shares decreased from $84 to $82 per share,
resulting in a decrease in the investment value of $5,000 (from $210,000 to $205,000). In both
cases, the gains and losses will be reported in the income statement as unrealized gains
(losses) on FVNI investments. The FVNI investment account would appear in the balance
sheet as shown below.
Lornelund Ltd.
Balance Sheet
December 31, 2020
Current assets:
FVNI investments (at fair value) * $370,000
*($150,000 + 210,000 + 15,000 − 5,000)
As previously mentioned, instead of recording the changes in fair value directly to the FVNI
investment account as shown above, companies will often record the changes to a valuation
allowance as a contra account to the FVNI investment account (asset). This separates and
preserves the original cost information from the fair value changes in much the same way as
the accumulated depreciation account for buildings or equipment. If a valuation allowance
contra account was used, the balance sheet would appear as follows:
Lornelund Ltd.
Balance Sheet
December 31, 2020
Current assets:
FVNI investments (at cost)* $360,000
Valuation allowance for fair value adjustments** $ 10,000
$370,000
* ($150,000 + 210,000)
**($15,000 − 5,000)
On January 10, 2021, the Symec shares were sold at $165.70 per share. As previously
explained, the shares can be remeasured to fair value prior to recording the sales proceeds,
or the entry can skip that step and record the sales proceeds with the gain/loss as realized
from sale of the investment. The entry above chose the latter, simpler alternative.
FVNI Investments in Debt
FVNI investments can also be bonds, if market fair values are determinable. On January
1, 2020, Osterline Ltd. purchases 7%, 5-year bonds of Waterland Inc. with a face value of
$500,000. Interest is payable on July 1 and January 1. The market rate for a bond with similar
characteristics and risks is 6%. The bond sells for $521,326.3
On December 31, the fair value of the bonds at year-end is $510,000. Osterline follows IFRS.
The interest is calculated using the effective interest method as shown below.
Effective Interest Method for 7% Bonds (market/yield rate 6%)

Cash Received Interest Income Amortized Premium
@ 3.5% stated rate @ 3% market rate (decreases
Date for 6 months for 6 months carrying value) Carrying Value
Jan 1, 2020 $521,326
Jul 1 17,500 15,640 1,860 519,466
Jan 1, 2021 17,500 15,584 1,916 517,550
Jul 1 17,500 15,527 1,973 515,577
Jan 1, 2022 17,500 15,467 2,033 513,544
Jul 1 17,500 15,406 2,094 511,450
Jan 1, 2023 17,500 15,344 2,156 509,294
Jul 1 17,500 15,279 2,221 507,073
Jan 1, 2024 17,500 15,212 2,288 504,785
Jul 1 17,500 15,144 2,356 502,429
Jan 1, 2025 17,500 15,073 2,429* 500,000
*rounded
Osterline’s journal entries from January 1, 2020 to July 1, 2021 are

shown below.
3
$521,326 is the present value of the bond’s future cash flows. Since the bond interest is being paid twice
per year, the number of payments is 10 payments (5 years × 2 payments per year) until the bond matures.
The market interest rate is 6% or 3% for each semi-annual interest payment. At maturity, $500,000 principal
amount of the bond is payable to the bondholder/investor. The present value can be calculated using a financial
calculator as follows: PV = 17,500 P/A, 3 I/Y, 10 N, 500,000 FV). For a review of present value techniques, refer
to Chapter 6: Cash and Receivables.
General Journal
Jan 1 2020 FVNI investments – Waterland bonds . . . . . . . . . . 521,326
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521,326
Jul 1 2020 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500

FVNI investments – Waterland bonds . . . . . . 1,860
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,640
For cash: ($500,000 × 7% × 6 ÷ 12), for Interest
income: ($521,326 × 3%)
Dec 31 2020 Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,584
For Interest receivable: ($500,000 × 7% × 6 ÷
12), for Interest income: (($521,326 − 1,860) ×
3%)
Dec 31 2020 Unrealized gain (loss) on FVNI investments. . . . 7,550

($521,326 − 1,860 − 1,916 − 510,000)
General Journal
Jan 1 2021 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500
Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . 17,500
Jul 1 2021 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,527
For Cash: ($500,000 × 7% × 6 ÷ 12), for Interest
income: (($521,326 − 1,860 − 1,916) × 3%)
The bond was initially valued and recorded at its purchase price (fair value) of $521,326.
Note that this is higher than the face value of $500,000. This is referred to as purchasing
at a premium, which is amortized to the FVNI investment account over the life of the bond
using the effective interest method. This method was also discussed in Chapter 6: Cash and
Receivables; review that material again, if necessary. There were no transaction costs, but
these would have been expensed as incurred just as was done in the previous FVNI shares
example.
The July 1, 2020, entry was for interest income based on the market rate (or yield) for 3% (6%
annually for six months), while the cash paid by Waterland on that date of $17,500 was based
on the stated or face rate for 3.5% (7% annually for six months). The $1,860 difference was
the amount of premium to be amortized to the FVNI investment account on that date. On Dec
31, there were two adjusting entries:
• The first entry was for the interest income that has accrued since the last interest pay-
ment on July 1. This interest entry must be done before the fair value adjustment to
ensure that the carrying value is up to date.
• The second adjusting entry is for the fair value adjustment which is the difference be-
tween the investment’s carrying value of $517,550 ($521,326 − 1,860 − 1,916) and the
fair value on that date of $510,000. Since the fair value is less than the carrying value,
this FVNI investment (or a valuation allowance) is reduced to its fair value by $7,550
($517,550 − 510,000). The investment carrying amount after the adjustment is now
equal to the fair value of $510,000.
It is important to note that the July 1, 2021, interest income of $15,527 calculated after the
fair value adjustment had been recorded continues to be based on the amounts calculated
in the original effective interest schedule. The interest rate calculations will continue to use
the original effective interest rate schedule amounts throughout the bond’s life, without any
consideration for the changes in fair value.
On July 1, 2021, just after receiving the interest, Osterline sells the bonds at the market rate
of 107. The entry for the sale of the bonds on July 1, 2021 is shown below.
General Journal
Jul 1 2021 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 535,000
Gain on sale of FVNI bonds . . . . . . . . . . . . . . . . 26,973
FVNI Investment – Waterland bonds . . . . . . . 508,027
For cash: ($500,000 × 1.07), for FVNI Invest-
ment: ($510,000 − 1,973)
Recall from the journal entries above that on December 31, 2020, the investment had been
reduced to its fair value of $510,000. On July 1, 2021, the interest entry included amortization
of the premium for $1,973, resulting in a carrying value as at July 1, 2021 of $508,027. The
market price for selling the investment was 107 resulting in a gain of $26,973. Note that this
entry skipped the remeasure to fair value as an unrealized holding gain and recorded the sale
entry as simply a gain on sale. Either method is acceptable.
ASPE companies can choose to use straight-line amortization of the bond premium instead of
the effective interest method. If straight-line was used, the amount recorded to the investment
account would be $2,133 ($21,326 ÷ 5 years × 6 ÷ 12) at each interest date until the investment
is sold.
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500
FVNI Investment – Waterland bonds . . . . . . . 2,133
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,367
Again, note that no separate impairment evaluations or entries are recorded since the debt
investment is already adjusted to its current fair value at each reporting date.
Investments in Foreign Currencies
Investments may be priced in foreign currencies, which must be converted into Canadian
currency for recording and reporting purposes. Illustrated below are the accounting entries for
a FVNI investment priced in a foreign currency.
FVNI investments purchased in foreign currencies are converted into Canadian currency using
the exchange rates at the time of the purchase. Also, depending on the accounting standard
and the circumstances of the investment, the fair value adjusting entry may have to separately
record the foreign exchange gain (loss) from the fair value adjustment amount.
For example, assume that the US dollar is worth $1.03 Canadian at the time of an investment
purchase for US $50,000 bonds at par. In Canadian dollars, the amount would be $51,500.
The entry to record the purchase would be:
General Journal
FVNI Investment – bonds. . . . . . . . . . . . . . . . . . . . . . 51,500
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51,500
(US $50,000 × 1.03)
At year-end, the fair value of the bonds is US $49,000 and the exchange rate at that time is
1.05. In Canadian dollars the amount would be $51,450 (US $49,000 × 1.05) compared to the
original purchase price in Canadian dollars of $51,500, an overall net loss of $50.
The entry to record the fair value adjustment separately from the exchange gain/loss would
be:
General Journal
Unrealized loss on FVNI investments . . . . . . . . . . 1,050
Foreign exchange gain . . . . . . . . . . . . . . . . . . . . . 1,000
FVNI Investment – bonds . . . . . . . . . . . . . . . . . . 50
For Unrealized loss: ((US $50,000 − 49,000)
× 1.05), for Foreign exchange gain: (US
$50,000 × (1.05 − 1.03)), for FVNI investment:
($51,500 − 51,450)
Note that the exchange rate increased from 1.03 to 1.05 for the US $50,000 investment
amount. This increase in the exchange rate resulted in a gain of Cdn $1,000 which was
recorded separately from the fair value adjustment loss of Cdn $1,050.
If there was no requirement to separate the exchange gain from the fair value adjusting entry,
the adjusting entry would be:
General Journal
Unrealized loss on FVNI investments . . . . . . . . . . 50
FVNI Investment – shares. . . . . . . . . . . . . . . . . . 50
($51,500 − 51,450)
8.2.2 Fair Value Through OCI Investments (FVOCI); (IFRS only)
Types of Investments Accounting Treatment

• Debt (bonds) • Interest and dividends through net income as earned/declared.
• Debt (bonds) • Remeasure investment to fair value at each reporting date

• Equities (shares) by through OCI. Can be recorded directly to investment or through
special irrevocable an asset valuation account.
election only at • Upon sale, remeasure investment sold to its fair value with
acquisition gains/losses through OCI.
• Reclassify the OCI for the debt investment sold to net income
(FVOCI with recycling), and to retained earnings for equities
investments (FVOCI without recycling).
Looking at the table above, one cannot help but notice how the FVOCI debt investments are
recycled through net income when sold in contrast to the FVOCI equities investments which
are not recycled, and are reclassified to retained earnings instead, bypassing net income
altogether. Originally, the FVOCI classification was without recycling for both debt and equity.
This was done to lessen the instances of “earnings management” which is the manipulation
of earnings due to bias. By timing the most opportune time to sell, a company could suddenly
boost net income resulting from the reclassification of OCI from AOCI to net income of the
unrealized gains dating back to when the investment was purchased. However, it appears
that an exception has now been made to allow FVOCI debt investments to recycle through net
income. FVOCI investments in equities continue to be classified as FVOCI without recycling.
FVOCI debt and equity investments are reported at their fair value at each balance sheet date
with fair value changes recorded in Other Comprehensive Income (OCI). Unlike FVNI invest-
ments, transaction costs are usually added to the carrying amount of the FVOCI investment,
and are usually reported as long-term assets unless it is expected they will be sold within
twelve months or the normal operating cycle.
The fair value measurement at each reporting date is recorded to the investment asset account
(or an asset valuation account). The unrealized holding gain (loss) is recorded to unrealized
gain (loss) OCI and reported in OCI (net-of-tax). When the investments are sold, a remea-
sure to fair value can precede the entry for the sales proceeds, or alternatively, any gains
(losses) resulting from the sale are reported in net income as a realized gain (loss) on sale of
investment.
This is the point where FVOCI investments in debt differ from FVOCI investments in equity.
For FVOCI, debt investment sold:
• any unrealized gain (loss) in AOCI at the time of the sale is reclassified from AOCI to net
income (with recycling).
For FVOCI, equity investment sold:
• any unrealized gain (loss) in AOCI at the time of the sale is reclassified from AOCI to
retained earnings (without recycling).
Recall from the chapter on Statement of Income and Statement of Changes in Equity, that OCI
is not included in net income, and is reported in a separate statement called the Statement of
Comprehensive Income. This means that any unrealized gains (losses) from holding FVOCI
investments will not be reported as net income until the debt investment is sold or impaired as
will now be discussed. Students are encouraged to review the material regarding the topic of
OCI.
Impairment of Investments with no recycling (Equity)
For FVOCI in equity investments, there is no need for impairment tests because equities are
continually re-measured to their fair value based on the readily available market prices and
these changes in value are not reported in net income, so impairment testing is not done. For
FVOCI investments in debt, impairments will be discussed in detail in the FVOCI with recycling
(debt) section later in this chapter.
FVOCI (without recycling) – Investments in Shares
The similarities and differences between FVNI and FVOCI investments journal entries will
be examined next, since both apply fair value remeasurements, but differ in how these are
recorded and reported. Using the same example for Lornelund Ltd. used in the FVNI invest-
ments above, a comparison between the entries required for FVNI and FVOCI is shown below.
The transactions are repeated below but now include another fair value change at the end of
2021.
Lornelund Ltd. – Non-Strategic Equity Investments

Dates # of Price per Total
in 2020 Transaction Detail Shares Share Amount
June 1 Purchased Symec Org. shares for $150 per share (transaction 1,000 $150.00 $150,000
costs were an additional $1.25 per share)
Aug 15 Purchased Hemiota Ltd. shares 2,500 84.00 210,000
Nov 30 Dividends for Symec declared and received 1,000 6.10 6,100
Dec 31 Market price for Symec shares at year-end 165.00
Dec 31 Market price for Hemiota shares at year-end 82.00
Dates
in 2021
Jan 10 Sold Symec shares 500 165.70 82,850
Dec 31 Market price for Symec shares at year-end $167.00
Dec 31 Market price for Hemiota shares at year-end $75.00
COMPARISON OF FVNI TO FVOCI (without recycling)

(FVNI) (FVOCI)
2020
June 1 Investments – Symec shares . . . . . . . . . . . . . . . . . . . . . . . . . 150,000 151,250
Transactions fees expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,250
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151,250 151,250
Aug 15 Investments – Hemiota shares . . . . . . . . . . . . . . . . . . . . . . . 210,000 210,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210,000 210,000
Nov 30 Cash (or dividend receivable if declared but not paid) . 6,100 6,100
Dividend income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,100 6,100
Dec 31 Investments – Symec shares . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 13,750

Unrealized gain (loss) on FVNI investments (NI) . . . . 15,000
($165 × 1,000 shares)
Unrealized gain (loss) on FVOCI investments (OCI) 13,750
($165,000 − 151,250)
NOTE – Both FVNI and FVOCI shares carrying

values for Symec are $165 per share × 1,000 =
$165,000.
Dec 31 Unrealized gain (loss) on FVNI investments (NI) . . . . . . 5,000

(($84 − 82) × 2,5000 shares)
Unrealized gain (loss) on FVOCI investments (OCI). . . 5,000
Investments – Hemiota shares . . . . . . . . . . . . . . . . . . . . . 5,000 5,000
NOTE – Both FVNI and FVOCI shares carrying

values for Hemiota are $82 per share × 2,500
= $205,000
2021
Jan 10 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82,850 82,850
Investments – Symec shares. . . . . . . . . . . . . . . . . . . . . . . 82,500 82,500
Gain (loss) on sale of investments (NI) . . . . . . . . . . . . . 350
Gain (loss) on sale of investments (OCI) . . . . . . . . . . . 350
For Cash: ($165.70 × 500 shares), For Investments:
($165 × 500 shares)
Jan 10 AOCI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,225

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,225
($13,750 × 500 ÷ 1,000 shares + 350)
To reclassify unrealized gains from AOCI to retained
earnings for 500 Symec shares sold.
Dec 31 Investments – Symec shares . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 1,000

Unrealized gain (loss) on FVNI investments (NI) . . . . 1,000
Unrealized gain (loss) on FVOCI investments (OCI) 1,000
(500 × ($165.00 − 167.00))
Dec 31 Unrealized gain (loss) on FVNI investments (NI) . . . . . . 17,500

Investments – Hemiota shares . . . . . . . . . . . . . . . . . . . . . 17,500
($205,000 − (2,500 × $75))
Unrealized gain (loss) on FVOCI investments (OCI). . . 17,500

FVOCI Investments – Hemiota shares. . . . . . . . . . . . . . 17,500
Note that the transaction fees are expensed for FVNI investments but are added to the carrying
value for FVOCI investments. At December 31 year-end, Lornelund makes two end-of-period
adjusting entries to record the latest fair values changes for each investment. The fair value
for Symec shares increased FVOCI $150 to $165 per share resulting in an increase in the
investment value by $15,000 and $13,750 for FVNI and FVOCI categories respectively. These
amounts are different due to the transaction costs originally recorded to the investment asset
of the FVOCI investment. The fair value for Hemiota shares decreased from $84 to $82 per
share resulting in a decrease in the investment value of $5,000 for both FVNI and FVOCI
investments.
Ignoring taxes for simplicity, below are the financial statements for 2020 under FVNI and
FVOCI:
Lornelund Ltd.
Balance Sheet
December 31, 2020
Current assets: FVNI FVOCI
FVNI investments (at fair value)* $370,000
Long-term assets:
Long-term investment (at fair value) $ 370,000
Equity:
Accumulated other comprehensive income ** $ 8,750
* FVNI ($150,000 + 210,000 + 15,000 − 5,000); FVOCI ($151,250 + 210,000 + 13,750 − 5,000)
** AOCI ($13,750 − 5,000)
There is no difference in the ending balances of the investment asset accounts under the
FVNI and FVOCI methods on December 31, 2020, because both are reported at fair value
at each reporting date. Even though the transaction costs were initially capitalized under the
FVOCI method, the year-end fair value adjustment entry for both FVNI and FVOCI investments
resulted in equalizing the investments balances.
Lornelund Ltd.
Income Statement and Comprehensive Income Statement (partial)
FVNI FVOCI
Dividend income $ 6,100 $ 6,100
Unrealized gain ($15,000 − 5,000) 10,000
Transaction fees expense (1,250)
Net income $ 14,850 $ 6,100
Other Comprehensive Income:

Items that may be reclassified
subsequently to net income or loss:
Unrealized gain from FVOCI investments ($13,750 − 5,000)
$ 8,750
Total comprehensive income $ 14,850 $ 14,850
At December 31, 2021 year-end, 50% of the Symec shares have been sold in January and the
fair values are once again adjusted for both Symec and Hemiota investments at year-end.
Below is a partial balance sheet and income statement reporting the investment at December
31, 2021.
Lornelund Ltd.
Balance Sheet
December 31, 2021
Current assets: FVNI FVOCI
FVNI investments (at fair value)* $271,000
Long-term assets:
Long-term investment (at fair value) $ 271,000
Equity:
Retained earnings $ 7,225
Accumulated other comprehensive income/loss ** (14,625)
* FVNI ($370,000 − 82,500 + 1,000 − 17,500); FVOCI ($370,000 − 82,500 + 1,000 − 17,500)
** AOCI ($8,750 + 350 − 7,225 + 1,000 − 17,500)
Lornelund Ltd.
Income Statement and Comprehensive Income Statement (partial)
FVNI FVOCI
Gain on sale of shares $ 350 $
Unrealized loss (17,500)
Net income/(loss) $(16,150)

Items that may be reclassified
subsequently to net income or loss:
Unrealized gain/loss from FVOCI investments $ (16,150)*
Total comprehensive income/(loss) $(16,150) $ (16,150)
* ($1,000 + 350 − 17,500)
As can be seen from the illustrations above, there are significant differences in net income,
due to the accounting treatments between FVNI and FVOCI investments. This could lead to
earnings management, if care is not taken to ensure that these differences are considered
solely for the purpose of managing net income to get higher bonuses, or fall under the radar
regarding any restrictive covenants (for example, net income minimum thresholds set by cred-
itors as performance targets). These differences also have to be taken into account when
analyzing investment portfolio performance.
FVOCI (with recycling) – Investments in Debt
FVOCI investments for IFRS companies can also be debt, such as bonds. FVOCI shares (no
recycling) reports dividends in net income and unrealized gains in OCI until sold, at which
time the OCI corresponding to the shares sold are reclassified from OCI/AOCI to retained
earnings. FVOCI debt (with recycling) reports interest in net income and unrealized gains in
OCI until sold. As the “with recycling” name suggests, when the debt securities are sold, the
corresponding OCI is recycled through net income.
Using the same example as for FVNI investments in bonds discussed earlier, where Osterline
Ltd. purchased 7%, 5-year Waterland bonds with a face value of $500,000. On July 1, 2021,
just after receiving the interest, Osterline sells the bonds at the market rate of 107. Osterline’s
journal entries from Jan 1, 2020 to July 1, 2021 classified as FVNI are repeated below and
compared with debt investments classified as FVOCI.
Osterline Ltd.
COMPARISON OF FVNI TO FVOCI debt (with recycling)
(FVNI) (FVOCI)
2020
Jan 1 Investments – Waterland bonds . . . . . . . . . . . . . . . . . . . . . . 521,326 521,326
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521,326 521,326
Jul 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500 17,500

Investments – Waterland bonds . . . . . . . . . . . . . . . . . . . . 1,860 1,860
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,640 15,640
For Cash: ($500,000×7%×6÷12), for Interest income:
($521,326 × 3%)
Dec 31 Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500 17,500

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,584 15,584
For Interest receivable: ($500,000 × 7% × 6 ÷ 12), for
Interest income: (($521,326 − 1,860) × 3%)
Dec 31 Unrealized loss on FVNI investment (NI). . . . . . . . . . . . . . 7,550

Unrealized gain (loss) on investments (OCI) . . . . . . . . . . 7,550
For NI: ($521,326 − 1,860 − 1,916 − 510,000)
2021
Jan 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500 17,500
Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500 17,500
Jul 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500 17,500

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,527 15,527
For Cash: ($500,000×7%×6÷12), for Interest income:
(($521,326 − 1,860 − 1,916) × 3%)
Jul 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 535,000 535,000

Gain on sale of Waterland bonds. . . . . . . . . . . . . . . . . . . 26,973
Gain on sale of Waterland bonds (OCI) . . . . . . . . . . . . 26,973
For Cash: ($500,000 × 1.07), for Investments:
($510,000 − 1,973)
Jul 1 OCI – removal of gain due to sale . . . . . . . . . . . . . . . . . . . . 19,473

Gain from sale of investment (NI) . . . . . . . . . . . . . . . . . . 19,473
($26,973 gain − 7,550 loss)
Note the similarities in accounting treatment between the FVNI and FVOCI classifications for
bonds. As was the case for the FVNI investment in shares, the investment is adjusted to fair
value at the reporting date. The difference between the two methods is the account used
for the fair value adjustment. For FVNI, the unrealized gain/loss is reported in net income,
whereas for FVOCI, the unrealized gain/loss is reported as Other Comprehensive Income
which is closed at each year-end to the AOCI account (an equity account), until the investment
is sold. Once sold, any unrealized gains/losses that relate to the sale of this investment are
now realized and are transferred from OCI to net income. This is referred to as “with recycling”
(through net income). Recall that FVOCI in equities do not recycle through net income. It is for
this reason that FVOCI investments in debt with recycling must be evaluated for impairment
which is discussed next.
Also note the order of the entries upon sale. The July 1 sales is comprised of two entries
above. The first entry is a combined entry that records the cash proceeds, removal of the
investment sold and any realized gain/loss through OCI. This is the same as the method used
for FVOCI equities. The second entry is a transfer of the OCI related to the sale from OCI to
net income. For FVOCI equities this entry is a reclassification from OCI to retained earnings.
This is an important distinction regarding the accounting treatment for the FVOCI investments.
Because the entire investment was sold, the net income differed in the first and second year
between FVNI and FVOCI with recycling, but over two years, the net income was the same for
both. If only part of the investment been sold, the differences would be similar to the example
regarding FVOCI equities, with regard to balances in the OCI/AOCI account compared to FVNI
where all the gains/losses are reported through net income.
Impairment of Investments – FVOCI with recycling (Debt)
For FVOCI in debt investments, an evaluation is done starting at its acquisition date. Under
IFRS 9, impairment evaluation and measurement is based on expected losses, and must now
reflect the basic principles below:
• An unbiased evaluation over a range of probability-based possible outcomes
• Estimated revised cash flows are discounted to reflect time value of money
• The evaluation and measurements are based on data from past, current and estimated
future economic conditions, using reasonable and supportable information without un-
due cost or effort at the reporting date
The last point suggests that a company does not need to identify every possible scenario
when risks are low, and companies are encouraged to use modelling techniques to simplify
evaluations and impairment measurements of large low-risk portfolios.
Essentially how it works is that for each investment at acquisition, various potential default
scenarios (where the debt owing is not paid when due) are identified. Expected future cash
flows are estimated for each scenario, which is multiplied by its probability of occurring. These
probability-based cash flows are summed, and the total is deemed as the expected credit
loss (ECL) for that investment. This is a separate evaluation and measurement of impairment
losses than fluctuations in the market.
These estimated cash flows can either be based on scenarios and probabilities of default over
the investment’s next 12 months (12-month ECL) from acquisition, if risk of default is low, or
over the investment’s lifetime (Lifetime ECL), if risk of default is higher. IFRS 9 identifies three
approaches for receivables and investments:
• Credit adjusted approach – for investments that are impaired at acquisition, such as
deeply discounted investments from high risk investee companies. This approach will
apply only rarely. Evidence of high risk could be due to significant financial difficulties or
potential bankruptcy, a history of defaults, a history of concessions granted by creditors
on previous debt, or economic downturns in the investee company’s industry sector. This
approach uses the cumulative change in Lifetime ECL.
• Simplified approach – this approach is intended specifically for trade receivables, IFRS
15 contract assets and lease receivables where the financial instrument does not contain
a significant interest component. It is based on Lifetime ECL
• General approach – this approach applies to all other financial instruments not covered in
the first two approaches. It is based on a 12-month ECL unless the credit risk increases
significantly.
If the credit risk is high at the investment’s acquisition, the credit adjusted approach with
Lifetime ECL will apply, otherwise the general approach would be used with the shorter 12-
month ECL. The end-result is that every investment will have an ECL amount associated with
it. These risk-based cash flows are discounted using the historic interest rate at acquisition,
and compared to the carrying value of the debt investment at the evaluation date. The carrying
value of the investment (or an asset valuation account) is reduced by the loss amount and
recorded to net income. Below is a schedule that illustrates a simple ECL calculation:
Investment in Bonds – Emil Ltd. Investee

Expected Credit Loss Calculation
Scenario 1 Scenario 2 Scenario 3 Total
Estimated future cash flows at

acquisition assuming no risk of
default, discounted @ effective
interest rate $ 500,000 $ 500,000 $ 500,000
Future cash flows if default
occurs, discounted @ historic
effective rate at acquisition 450,000 400,000 350,000
Cash flow shortage 50,000 100,000 150,000
Probability of default 2.0% 1.5% 0.5%
Expected Credit Loss (ECL) $ 1,000 $ 1,500 $ 1,750 $4,250
Management can include as many default scenarios as is appropriate. In this case, there are
three scenarios where management has identified potential defaults for this investment. If at
the first reporting date after acquisition the fair value of the investment is $480,000, the entry
to record the fair value change would be:
General Journal
Loss on impairment due to ECL (net income) . . 4,250
Unrealized loss in FV-OCI (OCI) . . . . . . . . . . . . . . . 15,750
FV-OCI investment (or asset valuation al- 20,000
lowance) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
For FV-OCI investment:
($500,000 face value − 480,000)
The unrealized loss of $15,750 is to adjust for changes in the market fluctuations that is not
due to an impairment, so it is recorded to OCI. The loss on impairment resulting from the
ECL calculation must be reported through net income. Compared to the previous accounting
standard (IAS 39), this results in an earlier recognition of an impairment loss because it is
recorded at the first reporting period after the investment acquisition. This clearly could create
more volatility in the income statement.
After the initial recognition, the ECL is adjusted up or down, through net income at each
reporting date as the probabilities of default change. Once the investment is collected, the
ECL will be reduced to zero and impairment recoveries will be reported through net income.
If default risk increases due to adverse changes in business conditions, not only will the
estimated cash flow shortages and probabilities increase, the increased credit risk could result
in a change from the simpler 12-month ECL to the Lifetime ECL if risk becomes too high. If a
default does occur, the ECL amount will equal the actual cash flow shortage. In IFRS 9, there
is a presumption that credit/default risk significantly increases if contractual payments from the
investee are more than 30 days past due.
To summarize, assessing credit risk is only required for amortized cost and FVOCI debt (with
recycling). FVNI and FVOCI equities do not need to be evaluated for impairment because
they are always remeasured to fair value each reporting date. Evaluating and measuring
impairments requires considerable judgement and companies are encouraged to establish an
accounting policy regarding factors to consider when determining if increases in credit risk
(ECL) is to be deemed as significant or not.
8.2.3 Amortized Cost Investments (AC)
For ASPE companies, either debt or equities that are not traded in an active market are
reported at amortized cost or cost respectively. Unlike investments acquired for short-term
profit such as FVNI investments, shares or bonds may be purchased as AC investments for
other reasons, such as to strengthen relationships with a supplier or an important customer.
For IFRS companies, if the investment business model is to acquire investments to collect the
contractual cash flows of principal and interest, and there is no intention to sell, investments
in debt securities such as bonds are reported at their amortized cost at each balance sheet
date. Management intent is to hold these investments until maturity, so debt instruments are
included in this category. Equity investments have no set maturity dates, therefore they are
not classified as an AC investment. Even if equities such as shares are not part of a quoted
market system, IFRS states that fair values are still normally determinable, making FVOCI
equities (without recycling) the more appropriate classification for unquoted equities.
Transactions costs are added to the investment (asset) account. AC investments are reported
as long-term assets unless they are expected to mature within twelve months of the balance
sheet date or the normal operating cycle.
To summarize the initial and subsequent measurements used for AC investments:
• Initial purchase is at cost (purchase price) which is also fair value on the purchase date.
Unlike FVNI investments, transaction fees are added to the investment (asset) account.
This is because AC investments are cost-based investments, so any fees paid to acquire
the asset are to be capitalized like property, plant, and equipment, which are also cost-
based purchases.
• Bond interest and share dividends declared are reported in net income as realized. Any
premium or discount is amortized to the investment asset using the effective interest rate
method (IFRS). For ASPE companies, they can choose between the effective interest
rate method and the straight-line method.
• If the investment is impaired, determine the impairment amount. For ASPE the im-
pairment amount is the higher of: a) the present value of impaired future cash flows
at the current market interest rate, and b) net realizable value through sale (or sale of
collateral). ASPE allows for reversals of impairment. For IFRS, refer to the Impairment
section above in the FVOCI debt (with recycling).
• Report the investment at its carrying value at each reporting date, net of any impairment.
As asset valuation account can be used instead of recording the impairment loss directly
to the investment account.
• When the investment is sold, remove the related accounts from the books. For debt
instruments, ensure that any interest, amortization or possible impairment recovery is
updated before calculating the gain/loss on sale prior to its removal from the books.
The difference between the carrying value and the net sales proceeds is reported as a
gain/loss on sale (including full or partial recovery of a previous impairment, if applicable)
and reported in net income.
AC Investments in Debt
In the previous sections discussing FVNI and FVOCI investments, Osterline purchased Wa-
terland bonds on the January 1, 2020, the interest payment date. Assume now that Osterline
classified this as an AC investment. The entries would be the same as illustrated earlier for
the FVNI category, except to exclude any fair value adjustments.
General Journal
Jan 1 2020 AC investments – Waterland bonds . . . . . . . . . . . . 521,326
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 521,326
Jul 1 2020 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500

AC investments – Waterland bonds . . . . . . . . 1,860
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,640
income: ($521,326 × 3%)

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,584
12), for Interest income: (($521,326 − 1,860) ×
3%)
Jan 1 2021 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500

Jul 1 2021 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,527
income: (($521,326 − 1,860 − 1,916) × 3%)
Jul 1 2021 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 535,000

Gain on sale of Waterland bonds . . . . . . . . . . . 19,423
For Cash: ($500,000 × 1.07), for AC invest-
ments: ($521,326 − 1,860 − 1,916 − 1,973)
Note that the entry to the investment account for the sale of Waterland bonds for the FVNI or
FVOCI methods shown earlier is $508,027 compared to AC method above for $515,577. The
reason for this difference is due to the fair value adjustment for $7,550 for the FVNI and FVOCI
methods (both fair-value based) but not done for AC method which is based on amortized cost.
AC Investments in Bonds – Between Interest Dates
What if the debt investment is purchased in between interest payment dates? Below is an
example of the accounting treatment for an AC investment in bonds that is purchased between
interest payment dates.
On March 1, 2020, Trimliner Co. purchases 6%, 5-year bonds of Zimmermann Inc. with a
face value of $700,000. Interest is payable on January 1 and July 1. The market rate for
a bond with similar characteristics and risks is 6.48%. The bond is purchased for $685,843
cash. Stated another way, the bond is purchased at 98 ($685,843 ÷ $700,000) on March 1,
2020. On December 31, 2020 year-end, the fair value of the bond at year-end is $710,000.
Trimliner follows IFRS and intends to hold the investment to collect the contractual cash flows
of principal and interest and to hold until maturity (AC classification).
Note that the purchase date of March 1 falls in between interest payments on January 1 and
July 1. The business practice regarding bond interest payments is for the bond issuer to pay
the full six months interest to the bond holder throughout the life of the bond. This creates a
much simpler bond interest payment process for the bond issuer, but it creates an issue for
the purchaser since they are only entitled to the interest from the purchase date to the next
interest date, or four months in this case, as illustrated below.
$21,000 × 2 ÷ 6 = $7,000
2 months 4 months
0
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This issue is easily resolved. The purchaser includes in the cash paid any interest that has
accrued between the last interest payment date on January 1 and the purchase date on March
1, or two months. In other words, the purchaser adds to the cash payment any interest that
they are not entitled to receive. Later, when they receive the full six months of interest on
July 1 for $21,000, the net amount received will be for the four-month period that was earned,
which was from the purchase date on March 1 to the next interest payment on July 1 as shown
above.
In this example, the purchase price of $685,843 is lower than the face value of $700,000, so
the bonds are purchased at a discount.
The entry to record the investment for Trimliner, including the interest adjustment on March 1,
2020 and the first interest payment on July 1, 2020, is shown below. Note that the discount is
also amortized from the date of the purchase of bonds to the end of the interest period.
General Journal
Mar 1 Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000
AC investment – Zimmermann bonds . . . . . . . . . . 685,843
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 692,843
12)
Jul 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000

AC investment – Zimmermann bonds . . . . . . . . . . 814
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,814
income: ($685,843 × 6.48% × 4 ÷ 12)
The net interest income recorded by Trimliner is $14,814 on July 1 ($685,843 × 3.24% × 4 ÷ 6),
which represents the four months interest earned from the March 1 purchase date to the first
interest payment date on July 1. The interest receivable is now eliminated.
Note that for AC bonds, there are no entries to adjust the AC investment to fair value at
year-end. The fair value information of $710,000 on December 31, 2020, that was provided
in the question data is not relevant for AC investments.
General Journal
AC investments – Zimmermann bonds. . . . . . . . . 1,248
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,248
12), for Interest income: (($685,843 + 814) ×
6.48% × 6 ÷ 12)
Jan 1 2021 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000

Jul 1 2021 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000

AC investments – Zimmermann bonds. . . . . . . . . 1,288
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,288
For Interest income: (($685,843 + 814 +
1,248) × 6.48% × 6 ÷ 12)
When the bonds mature at the end of five years, the entry to record the proceeds of the sale
is shown below.
General Journal
Jan 1 2025 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700,000
AC investment – Zimmermann bonds . . . . . . 700,000
As previously stated, ASPE companies can choose to use either the effective interest or the
straight-line method to amortize premiums or discounts. If straight-line method is used, the
discount for $14,157 ($700,000 − 685,843) will be amortized over five years. The amortization
amount for the July 1 entry would be for four months or $944 ($14,157 ÷ 5 years × 4 ÷ 12).
After that, the amortization will be for every six months or $1,416 ($14,157 ÷ 5 × 6 ÷ 12).
AC Impairment
For IFRS companies, the process to evaluate and measure impairments was already dis-
cussed in FVOCI debt (with recycling). The accounting treatment for impairments (IFRS) is
the same for both FVOCI debt with recycling and AC.
This section will now discuss impairment for ASPE companies with AC investments.
Since AC investments are measured at amortized cost for bonds and cost for shares, there is
always the possibility of an impairment loss since fair values are not used. For this reason,
investments should be assessed at the end of each reporting period to see if there has been
a loss event. Investment assets should be evaluated on both an individual investment and
portfolio (grouped) investment basis to minimize any possibilities of hidden impairments within
a portfolio of investments with similar risks. Below are details regarding how impairments for
AC investments are measured:
ASPE—reduce the investment carrying value to the higher of:
• the present value of impaired future cash flows using the current market interest rate and
• the net realizable value either through sale or by exercising the entity’s rights to sell any
collateral.
The loss is reported in net income and the investment (or an asset valuation allowance) is
reduced accordingly. These impairments may be reversed.
For example, assume that Vairon Ltd. purchased an investment in Forsythe Ltd. bonds for
$200,000 at par value on January 1 and intends to hold them until maturity. The bonds pay
interest on December 31 of each year. At year-end, Forsythe experiences cash flow problems
that are considered by the investor as a loss event that triggers an impairment evaluation. The
following cash flows are identified:
Present value of impaired cash flows using the current market rate $190,000
Net realizable value either through sale or by exercising
the investor’s rights to sell any collateral 185,000
For companies following ASPE, the entry for the AC investment in bonds would be:
General Journal
Loss on impairment of AC investments . . . . . . . . 10,000
AC Investment – Forsythe bonds . . . . . . . . . . . 10,000
Present value using higher of the current
interest rate of $190,000 and the net realizable
value of $185,000: ($200,000 − 190,000)
Changes in Classifications
Changes in management’s intention to sell or hold to maturity can result in a change in

classification. However, earlier in this chapter some significant impacts in net income and
investment asset values were illustrated between FVNI, FVOCI, and AC methods. It is easy
to see how this might lead to manipulation of net income or asset values by management. To
minimize this possibility, for ASPE, no reclassification is permitted unless there’s a change in
the company’s business model, which happens very rarely. For IFRS, there is the fair value
option discussed earlier for FVOCI equities, which is irrevocable.
8.3 Strategic Investments
In the previous categories, investments in other companies’ debt or shares were acquired in
order to make a return on idle cash. Investing in other companies can also be for strategic
purposes, such as to acquire the power to influence the board of directors and company
policies, or to take over control of the company outright. This is done by acquiring various
amounts of another company’s voting common shares. The degree of ownership (number of
votes) defines the level of influence.
8.3. Strategic Investments 313
Strategic Investments
(voting shares)
Associate Subsidiary
Joint Arrangements
(Significant Influence) (Control)
various % ownership
20% - 50% ownership 50% - 100% ownership
Guidelines have been developed to help determine the classification of the investment based
on the degree of influence. For example, the previous three categories of investments (FVNI,
FVOCI, and AC) each assumed that the investor’s ownership in shares were less than 20%,
therefore having no influence on the investee company.
For ownership in shares greater than 20% but less than 50%, it is assumed that significant
influence exists. IFRS calls this category investment in associates. However, if an investing
company owns between 20% and 50% of another company’s shares, significant influence is
by no means assured and can be refuted, if there is evidence to the contrary. For example, if
an investor acquires 40% of the outstanding common shares of a company but the remaining
60% of the shares are held by one other investor, then significant influence will not exist. A
general assumption is that the greater the number of investors, the more likely that investment
holdings of greater than 20% will result in significant influence.
If an investor holds greater than 50% of the common shares, then it has the majority of the
votes at the board of directors’ meetings, thereby having control of the investee company’s
operations, decisions and policies.
Joint arrangements is another type of strategic investment that involves the contractually-
agreed sharing of control by two or more investors. There are two types of joint arrangements,
namely; joint operations and joint ventures. A joint operation exists if the investor has rights to
the assets and unlimited liability obligations of the joint entity and a joint venture exists if the
investor has rights to net assets (assets and limited liability obligations of the joint entity.
Regarding strategic investments—why would an investor want to influence or control another

company? If the investee company has resources that would enhance the operations of
the investor, then acquiring sufficient voting shares to significantly influence or control the
investee’s board of directors would be a prime motivator to do so. Acquiring an interest in
another company could secure a guaranteed source of materials and products, open up new
markets, or broaden existing ones for the investor company. It could also expand an investor
company’s range of products and services available for sale as was the case with Hewlett
Packard’s acquisition of 87% of Autonomy Corporation’s shares resulting in control of the
company.
The accounting treatments for these classifications are complex and will be covered in more
detail in the advanced accounting courses. The rest of this chapter will focus on an introduction
to the three strategic investment classifications.
8.3.1 Investments in Associates (Significant Influence)
For IFRS, investments between 20% and 50% of the voting shares in another company are
reported using the equity method. For ASPE companies, management can choose the equity
method, the fair value through net income method (if this investment is traded in an active
market), or the cost method if no market exists. Transactions costs are expensed for the equity
and fair value methods and added to the investment (asset) account for the cost method.
Investments in associates are reported as long-term investments and income from associates
is to be separately disclosed.
This chapter has already discussed the fair value and cost models, so the focus will now be on
the equity method.
The equity method initially records the shares at the cost of acquiring them which is also fair
value. Subsequent measurement of the investment account includes recording the proportion-
ate share of the investee’s:
• net income (loss) adjusted for any inter-company transactions
• dividends
• amortization of any fair value difference in the investee’s capital assets
• impairments, if any
• proceeds of sale
The equity method is often referred to as the one-line consolidation because all the related
transactions are recorded as increases or decreases in a single investment asset account.
For example, if the investee company reported net income, this would result in a proportionate
increase in the investor’s investment (asset) due to the added profit. Conversely, a net loss
reported or dividend received would be recorded as a proportionate decrease in the invest-
ment. Any amortization of fair value adjustments from the date of purchase or impairment
would also be recorded as a decrease in the investment account. Below is an example of how
the investment is accounted for using the equity method.
On January 1, 2020, Tilton Co. purchased 25% of the 100,000 outstanding common shares
of Beaton Ltd. for $455,000. Beaton currently is one of Tilton’s suppliers of manufactured
goods. The outstanding shares are widely held, so with this purchase, Tilton can exercise
significant influence over Beaton. This investment solidified the relationship between Tilton
and will guarantee a steady supply of goods needed by Tilton for its customers. The following
financial information relates to Beaton:
Total 25% Note

Amount paid by Tilton for 25% shares of Beaton $455,000 1
Book value of Beaton’s net assets on January 1, 2020 $1,500,000 375,000
Excess of the amount paid from the net book value 80,000
Fair value allocation of excess paid for net 240,000 60,000 4
depreciable assets
Remaining life of Beaton’s depreciable assets as 10 years
at January 1, 2020
Unexplained excess assumed to be goodwill 20,000
Dividends declared and paid on December 31, 2020 150,000 37,500 2
Net income for the year ended December 31, 2020 250,000 62,500 3
Below are the entries recorded to Tilton’s books that relate to its investment in Beaton:
General Journal
Jan 1 2020 Investment in associate – Beaton shares . . . . . . 455,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 455,000
Note 1: Purchase of 25% of Beaton’s common
shares
Dec 31 2020 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,500

Investment in associate – Beaton shares . . . 37,500
Note 2: 25% share of dividends received
Dec 31 2020 Investment in associate – Beaton shares . . . . . . 62,500

Investment income (loss). . . . . . . . . . . . . . . . . . . 62,500
Note 3: 25% share of net income for 2020
Dec 31 2020 Investment income (loss) . . . . . . . . . . . . . . . . . . . . . . 6,000

Note 4: Amount of excess price paid for net
depreciable assets amortized over 10 years.
($60,000 ÷ 10 years)
On December 31, Tilton recorded its 25% share of dividends received, net income (loss), and
amortization of Beaton’s net depreciable assets. But what about the $80,000 excess paid for
the investment? The excess of $60,000 relates to Beaton’s net depreciation assets, so this
portion of the excess is amortized over ten years. The remaining $20,000 is inexplicable, so it
will be treated as unrecorded goodwill. Goodwill is discussed in detail in Chapter 11: Intangible
Assets and Goodwill. Since there is unrecorded goodwill, an intangible asset, Tilton must
evaluate its investment each reporting date to determine if there has been any impairment in
the investment’s value.
Below is a partial balance sheet and income statement reporting the investment at December
31, 2020.
Tilton Co.
Balance Sheet
December 31, 2020
Long-term investment:
Investment in associates (equity method)* $474,000
*($455,000 − 37,500 + 62,500 − 6,000)
For IFRS, investments in this classification are assessed each balance sheet date for possible
impairment. If it was determined that the investment’s recoverable amount—being the higher
of its value in use (the present value of expected cash flows from holding the investment,
discounted at the current market rate) and fair value less costs to sell, both of which are
discounted cash flow concepts—was $460,000, then the carrying value is more than the
recoverable amount and an impairment loss of $14,000 ($460,000 − 474,000) is recorded
as a reduction to the investment (or valuation account) and to net income (loss).
General Journal
Loss due to impairment . . . . . . . . . . . . . . . . . . . . . . . 14,000
For ASPE, impairment evaluation and measurement is the same as IFRS except “fair value”
does not include netting the costs to sell.
Since there is $20,000 of unrecorded goodwill, the $14,000 impairment charge represents a
loss in an intangible asset and is therefore not reversible. If there had been no unrecorded
goodwill, any subsequent impairment charge would be reversible, but limited and the recov-
ery amount could not result in a carrying value balance greater than if there had been no
impairment.
8.3.2 Investments in Subsidiaries (Control)
For IFRS, investments greater than 50% of the voting shares in another company are reported
using the consolidation method. For ASPE companies, there is a choice of consolidation,
equity, or cost methods. Transactions costs are expensed for the consolidation and equity
methods and added to the investment (asset) account for the cost method.
For IFRS companies, the investor is referred to as the parent, and the investee as the sub-
sidiary, and it is reasonable to treat the two companies as one economic unit and prepare a
consolidated set of financial reports for the combined entity. This means that the investment
account is eliminated and 100% of each asset and liability of the subsidiary is reported within
the parent company’s balance sheet on a line-by-line basis. For example, the accounts receiv-
able ending balance for the subsidiary would be added to the accounts receivable balance of
the parent and reported as a single amount on the consolidated balance sheet. This would be
done for all of the subsidiary’s assets and liabilities sheet accounts. As well, 100% of each of
the subsidiary’s revenues, expenses, gains, and losses accounts would be included with those
of the parent company and reported in the consolidated income statement.
Since 100% of all the net assets and net income (loss) is being reported by the parent, any
percentage of ownership held by outside investors, referred to as the minority interest, must
also be reported in the financial statements. This is reported as a single line in the balance
sheet and the income statement as non-controlling interest. For example, in the cover story,
Hewlett Packard purchased a majority of the voting shares of Autonomy Corp. The remaining
percentage would be the minority interest shareholders who did not sell their shares to Hewlett
Packard and continue to be investors of Autonomy Corp. This non-controlling interest would
be reported as a single line in the balance sheet and the income statement. Earlier chapters
regarding the income statement and statement of financial position both illustrate how the
non-controlling interest is presented in these financial statements.
8.3.3 Investments in Joint Arrangements
As previously stated in the overview of strategic investments, joint arrangements is another

type of strategic investment for both IFRS and ASPE that involves a contractual arrangement
between two or more investors regarding control of a joint entity. Control in this case means
that the investors must together agree on the decision-making. For IFRS, there are two types
of joint arrangements:
• Joint operations—investor has direct rights to assets and (unlimited) liability obligations
of the joint entity, such as a partnership where liability can be unlimited. Each investor
would include in their financial statements the assets, liabilities, revenue, and expenses
that they have a direct interest in. In other words, it is a form of proportionate consol-
idation where the investor’s proportionate share of the assets, liabilities, revenue and
expense accounts from the joint entity are added to the investor’s existing accounts.
• Joint ventures—investor has rights to net assets (assets and (limited) liability obligations)
of the joint entity, such as the case involving corporations with limited liability. The equity
method is used for this type of investment which is the method illustrated for investments
in associates above. In this case, the joint entity is shown on a net basis in an investment
account on the statement of financial position.
The ASPE standards are very similar, though the terms are a bit different, namely, jointly
controlled operations, jointly controlled assets, and jointly controlled enterprises. ASPE com-
panies can make a policy choice to use proportionate consolidation, equity, or cost to account
for their joint entity investments. Once chosen, the method must be applied to all investments
of this nature.
8.4 Investments Disclosures
Reporting disclosures were addressed under each accounting method above. To summarize,
investments will be reported as either current or long-term assets on the same basis as other
assets. If the investment is expected to be sold within twelve months of the balance sheet date
(or its operating cycle), is held for trading purposes, or is a cash equivalent, it will be reported
as a current asset. All other investments will be reported as long-term assets. Both IFRS and
ASPE companies are similar regarding this classification. IFRS and ASPE standards are also
similar regarding the disclosure objectives for investments for the following reasons:
• to ensure that information is available to assess the level of significance of the overall
financial position and performance of the investments
• to understand the nature and extent of risks arising from the investments
• to know how these risks are managed
Examples of disclosure details are:
• separation of investments by type (i.e., FVNI, AC, FVOCI, Significant Influence, Sub-
sidiary, Joint arrangements)
• the carrying value of investments with details about their respective fair values including
valuation techniques, interest income, unrealized and realized gains (losses), impair-
ments and reversals of impairments, and reclassifications
• information from the legal documents including maturity dates, interest rates, and collat-
eral
• information regarding market risk, liquidity risk, and credit risk, as well as the policies in
place to manage risks
• IFRS for impaired assets must disclose the basis for the ECL and changes in ECL as well
as a breakdown and reconciliation of the reporting year’s adjustments of any impairment
allowance accounts
8.5. Investments Analysis 319
Since investments are also financial instruments, the disclosure requirements identified in
Chapter 6: Cash and Receivables apply to intercorporate investments as well. Refer to that
chapter for more details.
8.5 Investments Analysis
Access to the information contained in financial statements and required disclosures is vital to
sound investment analysis. This information will assist management to separate the assets,
liabilities, and income components of the investment portfolios from the company’s core oper-
ations to accurately assess performance of the company and of the investment itself. As well,
creditors and potential investors will have to keep in mind the impact that certain accounting
treatments would have on existing financial data. The equity method was referred to earlier
as the one-line consolidation method for a reason: some of the key data using this method is
not separately identifiable. As well, the accounting treatment chosen could affect the amounts
and timing of net income and assets balances reported by the investor company. Some of
these differences are identified in the chapter highlights below. Decisions regarding when
to purchase or sell are in part determined by analysis of the investee company’s operating
results, earnings prospects, and earnings ratios. For this reason, care must be taken to clearly
be aware of any obscured data and to understand the differences in data created by the choice
of accounting treatments for each investment portfolio. Proper access to information and a
thorough understanding of the various accounting treatments will reduce the possibility that
management will make sub-optimal business investment decisions due to misinterpretation of
analysis results.
There is no doubt that accounting for investments is complex, given the presence of two
accounting standards that have identified eight separate categories for IFRS and ASPE as
shown in the Classifications chart at the beginning of this chapter.
Below is a decision map for the various equity investment categories:
Corporate
Std Description Planning Purpose Treatment
IFRS If voting shares Strategic Control Full consolidation
ownership is
greater than 50%
If voting shares Strategic Associate Equity method

ownership is
between 20% and
50%
If equity Non-strategic For trading FVNI – fair value –
investment is less purposes (FVNI) net income
than 20%
If equity Non-strategic To collect Fair value – OCI
investment is less dividends and also without recycling
than 20% to sell (FVOCI) (equities)
ASPE If voting shares Strategic Subsidiary Choice of

ownership is consolidation,
greater than 50% equity method, or
cost method
If voting shares Strategic Significant Choice of equity
ownership is influence method or cost
between 20% and method, or fair
50% value (if market
exists) – net
income
If equity Non-strategic Short-term trading FVNI – fair value –
investment is less net income
than 20% and has
an active market
If equity Non-strategic All other equities Cost
investment is less
than 20% and has
no active market
Chapter Summary
LO 1: Describe intercorporate investments and their role in accounting and

business.
Non-strategic intercorporate investments exist when companies invest in other companies’

equity (shares or derivatives) or debt (bonds or convertible debt) to earn a better return on
their idle cash. These returns will take the form of interest income, dividend income, or capital
appreciation of the security itself.
Strategic intercorporate investments are voting shares purchased by the investor company to
Chapter Summary 321
enhance its own operations. The goal is to either influence the investee’s board of directors
(share holdings 20% or greater) or to take control over the company (share holdings 50% or
greater). This is undertaken in order to guarantee a source of scarce materials or services
or to increase sales and hence profit. There are also joint arrangements where two or more
investors, through a contractual agreement, control a joint entity.
Intercorporate investments are financial assets because the investor’s contractual rights to
receive cash or other assets of the investee company result in a financial liability or equity
instrument of the investee. They are reported as either current or long-term investments
depending on the investments business model and if management intends to hold and collect
interest and dividends or to realize changes in their value through selling them.
For all investments, the initial measurement is the acquisition price (which is equal to the fair
value) in Canadian funds. For equity investments this would likely be the market price and for
debt investments such as bonds, it would be the future cash flows discounted using the market
interest rate (net present value). Subsequent measurement will depend on the category of the
investment. For non-strategic investments, IFRS has three categories: a) FVNI for trading and
measured at fair value through net income; b) AC to hold and collect cash flows and measured
at amortized cost; and c) FVOCI to collect cash flows and to sell, measured at fair value
through OCI with recycling (debt) or without recycling (equities). ASPE has two categories:
a) investments for trading purposes (FVNI); and b) all other investments at cost or amortized
cost. Strategic investments have three categories: a) holdings of 20% or greater (associate
or significant influence) which uses the equity method (IFRS); b) holdings of 50% or greater
(subsidiary or control) which uses consolidation (IFRS); and c) joint arrangements made up
of various percentages, using the equity method for joint ventures or a form of proportionate
consolidation for joint operations. ASPE allows some other choices of methods for its strategic
investments and permits straight-line amortization of its debt instruments. The ownership
percentages are guidelines only and there can be exceptions to these.
LO 2: Identify and describe the three types of non-strategic investments.
Held-for-trading (FVNI) investments in debt, equity, or derivatives are held for short periods
of time. For ASPE companies, these are for equities trading in an active market, debt, or
most derivatives under the fair value option (classification irrevocable, once made). FVNI
investments are reported as current assets at fair value through net income at each balance
sheet date. Transaction costs are expensed. Gains (losses) upon sale are reported in net
income. Since they are reported at fair value, no separate impairment tests or charges are
required. Investor companies often use an asset valuation allowance account (contra account
to the investment asset) to record changes in fair value to preserve the original cost information
for the investment. For debt instruments such as bonds, any amortization is calculated using
the effective interest method for IFRS. ASPE companies can also elect to use straight-line
method for its amortization.
FVOCI investments in debt or equity are for sale, but also for the purpose of collecting the
cash flows of interest and dividends. This classification is only available for IFRS companies.
They are reported as long-term assets (until within twelve months of the intention to sell
them) at fair value through OCI at each balance sheet date until sold. Transactions costs
are capitalized. For FVOCI investments in debt, gains/losses upon sale are transferred from
OCI to net income. For FVOCI investments in equities, gains/losses upon sale are reclassified
from AOCI to retained earnings. Impairment evaluations begin as soon as the investment is
acquired and estimated costs regarding potential defaults (expected credit losses or ECL) are
calculated and reported at the first reporting date after acquisition. The ECL is adjusted up or
down depending on if credit risk increasing or decreasing.
For IFRS, AC investments in debt are reported at amortized cost at each balance sheet
date. ASPE companies can also classify equity securities not traded in an active market
to this category at cost. Transaction costs are capitalized. AC investments are reported at
their carrying value as long-term assets, unless they are expected to mature within twelve
months of the balance sheet date. Interest earned on investments in debt (bonds), and
dividends earned on equity securities measured at cost, are reported in net income. Any
bond premium or discount amortization is calculated using the effective interest rate method
for IFRS companies. ASPE can choose to use either the effective interest or the straight-line
method. For ASPE, if a loss event occurs, any impairment is calculated as the difference
between the carrying value and the present value of the impaired cash flows using the current
market rate. Any gain (loss) due to impairment or upon sale is reported in net income. An
asset valuation allowance can be used for either standard and any of the classifications.
For IFRS, impairment evaluations for AC investments are the same process as for FVOCI debt.
To summarize, impairment evaluations begin as soon as the AC investment is acquired and
estimated costs regarding potential defaults (expected credit losses or ECL) are calculated
and reported at the first reporting date after acquisition. The ECL is adjusted up or down
depending on if credit risk increasing or decreasing.
LO 3: Identify an describe the three types of strategic investments.
Investments in the voting shares of an investee company are undertaken to influence or take
over control of the board of directors. The degree of ownership defines the level of influence
and the classification.
Associate (Significant Influence) investments of 20% or greater voting shares are reported
using the equity method for IFRS. For ASPE, management can choose the equity method, the
fair value method through net income if traded in an active market, or the cost method if no
market exists. Transaction costs are expensed for the equity and fair value methods and added
to the investment (asset) account for the cost method. Investments in associates are reported
as long-term investments and income from associates is to be separately disclosed on the
income statement. The equity method is based on a reflection of ownership in the investee
Chapter Summary 323
company. Dividends received are treated as a return of some of the investment asset and are
recorded as a reduction in the value of the investment. Conversely, the investor company’s
share of an associate’s reported net income is added to the value of the investment. Included
in the journal entries are also any excess amount paid that is attributable to the investee’s net
identifiable assets amortized over the remaining life of the assets. Any remaining excess is
usually attributable to unrecorded goodwill. Any impairment charge other than those attributed
to unrecorded goodwill is recoverable, but limited.
Investments in subsidiaries (Control) for greater than 50% of the voting shares in another
company are reported using the consolidation method for IFRS. For ASPE companies, there
is a choice of consolidation, equity, or cost methods. Transaction costs are expensed for
the consolidation and equity methods and added to the investment (asset) account for the
cost method. Consolidation involves the elimination of the investment account, and 100%
of each asset and liability of the subsidiary is incorporated on a line-by-line basis with the
assets and liabilities of the parent company’s balance sheet. As well, 100% of the revenues,
expenses, gains, and losses are also incorporated on a line-by-line basis in the parent com-
pany’s consolidated statement of income. If the parent company owns less than 100%, then
a minority interest held by other shareholders exists. This is reported as a single line called
non-controlling interest in the parent company’s consolidated balance sheet and consolidated
income statement.
The investments in joint arrangements classification is used when there are multiple investors
each having direct rights to the assets and obligations of the joint arrangement. The degrees of
ownership can be varying percentages, and are reported in each investor company using the
proportionate consolidation method for IFRS. For ASPE companies, there is a choice of using
proportionate consolidation, equity, or cost. The mechanics of the proportionate consolidation
method are similar to the consolidation method discussed above.
LO 4: Explain disclosures requirements for intercorporate investments.
The various classifications and accounting treatments can significantly impact the asset values
and net income of investor companies. Accounting methods in this chapter can obscure some
of the key data and stakeholders may have difficulty distinguishing between performance of
the investor’s core operations and those of its investments. Investment decisions to buy or
sell are based on this information so it is critical to be aware of any obscured data that could
influence these decisions.
LO 5: Identify the issues for stakeholders regarding investment analyses of

performance.
Analyzing the performance of a company’s portfolio of intercorporate investments is a critical

process. The most significant hurdle to good investment management is to ensure that the
information used to assess performance is clearly understood by those performing the analysis
and interpreting the results, since some of the critical data can be obscured by the choice of
accounting treatment. Investments have three potential accounting categories for both non-
strategic (FVNI, FVOCI, AC) and strategic (associate, control, joint arrangements) investments.
As well, accounting treatments can also vary between debt instruments and equity securities
within a specific classification, making comparisons with other benchmark data (e.g., historic
or industry ratios) difficult, and hence performance assessment challenging as well. The result
is that both net income and investment accounts balances can differ widely at each reporting
date depending on the category classification chosen to account for the investment(s).
LO 6: Discuss the similarities and differences between IFRS and ASPE for the
three non-strategic investment classifications.
A decision map assists in determining the proper treatment for various types of investment
decisions.
References
Hewlett Packard. (2011, October 3). HP acquires control of Autonomy Corporation plc [press
release]. Retrieved from http://www8.hp.com/us/en/hp-news/press-release.html?id=
1373462#.V5omfPkrJph
IFRS. (2011, December 16). IFRS 9 mandatory effective date and disclosures. Retrieved from
http://www.ifrs.org/Current-Projects/IASB-Projects/Financial-Instruments-A-R
eplacement-of-IAS-39-Financial-Instruments-Recognitio/IFRS-9-Mandatory-effec
tive-date-and-disclosures/Pages/IFRS-9-Mandatory-effective-date-and-disclosu
res.aspx
IFRS. (2014). IFRS 9 financial instruments (replacement of IAS 39). Retrieved from http://w
ww.ifrs.org/current-projects/iasb-projects/financial-instruments-a-replaceme
nt-of-ias-39-financial-instruments-recognitio/Pages/financial-instruments-re
placement-of-ias-39.aspx
Souppouris, A. (2012, November 20). HP reports $8.8 billion ‘impairment charge’ due to al-
legedly fraudulent Autonomy accounting. The Verge. Retrieved from http://www.theverge.
Exercises 325
com/2012/11/20/3670386/hp-q3-2012-financial-results-autonomy-fraud-allegatio
n
Webb, Q. (2012, December 10). Did HP just lost $5 billion through bad accounting? Slate.com.
Retrieved from http://www.slate.com/blogs/breakingviews/2012/12/10/how_did_hp_
lose_five_billion_dollars_through_bad_accounting.html
Exercises
EXERCISE 8–1
On January 1, Maverick Co. purchased 500 common shares of Western Ltd. for $50,000 plus
a 1% commission of the transaction. On September 30, Western declared and paid a cash
dividend of $2.25 per share. At year-end, the fair value of the shares was $108 per share. In
early March of the following year, Maverick sold the shares for $57,000 less a 1% commission.
The shares are not publicly traded, so Maverick will account for them using the cost method.
Maverick follows ASPE.
Required:
a. Describe the type of investment and how it would be reported.
b. Prepare the journal entry for the purchase, the dividends received, and the sale, and any
year-end adjustments, if required.
c. Assume now that Maverick follows IFRS and the investment in shares is accounted for
as FVNI investment. Prepare the journal entry for the purchase, the dividends received,
any year-end adjusting entries and the sale.
d. How would your answer to part (c) change if Maverick follows ASPE and the shares are
traded on an active market?
EXERCISE 8–2
On January 1, 2020, Smythe Corp. invested in a 10-year, $25,000 face value 4% bond, paying
$25,523 in cash. Interest is paid annually, every January 1. On January 3, 2028, Smythe sold
all of the bonds for 101. Smythe’s year-end is December 31 and the company follows IFRS.
At the time of purchase, Smythe intended to collect the contractual cash flows of interest and
principle, and to hold the bonds to maturity.
Required:
a. What is the effective interest rate for this bond, rounded to the nearest whole dollar?
(Hint: this involves a net present value calculation as discussed in Chapter 6: Cash and
Receivables.)
b. What is the amount of the bond premium or discount? Indicate if it is a premium or a

discount.
c. Record all relevant entries for 2020, the January entry for 2021, and the entry for the
sale in 2028, if Smythe classifies the investment as an AC investment. Round amounts
to the nearest whole dollar.
d. What is the total interest income and net cash flows for Smythe over the life of the bond?
What accounts for the difference between these two amounts?
e. Assume now that Smythe follows ASPE. How would the entries in part (c) differ? Use
numbers to support your answer.
EXERCISE 8–3
On January 2, Terrace Co. purchased $100,000 of 10-year, 4% bonds from Inverness Ltd. for
$88,580 cash. The effective interest yield for this transaction is 5.5%. The bonds pay interest
on January 1 and July 1. Terrace’s business model is to hold and collect the contractual cash
flows of interest and principal until maturity. The company follows IFRS and their year-end is
December 31.
Required:
a. What is the discount or premium, if any, for this investment? Explain why a premium or
discount could occur when purchasing bonds.
b. Record the bond purchase, the first two interest payments, and any year-end adjusting
entries, rounding amounts to the nearest whole dollar.
c. Record the entries from part (b), assuming now that Terrace follows ASPE and has
chosen the alternative method to account for the premium or discount, if any.
EXERCISE 8–4
On January 2, Bekinder Ltd. purchased $100,000 of 10-year, 4% bonds from Colum Ltd. for
$88,580 cash. The effective interest yield for this transaction is 5.5%. The bonds pay interest
on January 1 and July 1. Terrace follows IFRS and classifies this investment as AC. Their
year-end is September 30.
Exercises 327
Required: Record the first two interest payments and any adjusting entries, rounding amounts
to the nearest whole dollar.
EXERCISE 8–5
On March 1, Imperial Mark Co. purchased 5% bonds with a face value of $20,000 for trading
purposes. The bonds were priced in the trading markets at 101 to yield 4.87%, at the time of
the purchase, and pay interest annually each July 1. At year-end on December 31, the bonds
had a fair value of $21,000. Imperial Mark follows IFRS.
Required:
a. What classification would Imperial Mark use to report this investment?
b. Prepare the journal entries for the bond purchase, the first interest payment, and any
year-end adjusting entries required. Round amounts to the nearest whole dollar.
c. Assume now that Imperial Mark follows ASPE. How would Imperial Mark classify and
report this investment? Prepare the journal entries from part (b) using the ASPE classifi-
cation and the alternate method to amortize the premium. Assume that bond investment
matures in ten years.
EXERCISE 8–6
Halberton Corp. purchased 1,000 common shares of Xenolt Ltd., a publicly traded company,
for $52,800. During the year Xenolt paid cash dividends of $2.50 per share. At year-end, due
to a temporary downturn in the market, the shares had a market value of $50 per share. Hal-
berton’s business model is to collect the dividend cash flows for now, and sell this investment
if/when the share price reaches 54,000. Halberton follows IFRS and has elected to classify
this investment as FVOCI equities, with recycling to best fit with their intentions to sell, but at a
later date.
Required:
a. How would Halberton report this investment?
b. Prepare Halberton’s journal entries for the investment purchase, the dividend, and any
year-end adjusting entries. Is the drop in market price due to an investment impairment?
c. Prepare the sale entry if Halberton sells the investment one week into the next fiscal
year for $54,200 cash.
d. How would the answer for part (a) change if Halberton followed ASPE?
EXERCISE 8–7
The following are various transactions that relate to the investment portfolio for Zeus Corp., a
publicly traded corporation. The portfolio is made up of debt and equity instruments all pur-
chased in the current year and accounted for as investments for trading (FVNI). The investee’s
year-end is December 31.
a. On February 1, the company purchased Xtra Corp. 12% bonds, with a par value of
$500,000, at 106.5 plus accrued interest to yield 10%. Interest is payable April 1 and
October 1.
b. On April 1, semi-annual interest was received on the Xtra bonds.
c. On July 1, 9% bonds of Vericon Ltd. were purchased. These bonds, with a par value of
$200,000, were purchased at 101 plus accrued interest to yield 8.5%. Interest dates are
June 1 and December 1.
d. On August 12, 3,000 shares of Bretin ACT Corp. were acquired at a cost of $59 per
share. A 1% commission was paid.
e. On September 1, Xtra Corp. bonds with a par value of $100,000 were sold at 104 plus
accrued interest.
f. On September 28, a dividend of $0.50 per share was received on the Bretin ACT Corp.
bonds.
g. On October 1, semi-annual interest was received on the remaining Xtra Corp. bonds.
h. On December 1, semi-annual interest was received on the Vericon Ltd. bonds.
i. On December 28, a dividend of $0.52 per share was received on the Bretin ACT Corp.
shares.
j. On December 31, the following fair values were determined: Xtra Corp. 101.75; Vericon
Ltd. bonds 97; and Bretin ACT Corp. shares $60.50.
Required: Prepare the journal entries for each of the items (a) to (j) above. The company
wishes to record interest income separately from other investment gains and losses.
EXERCISE 8–8
Exercises 329
On January 1, 2020, Verex Co. purchased 10% of Optimal Instrument’s 140,000 shares for
$135,000 plus $1,750 in brokerage fees. Management accounted for this investment as a
FVOCI. In October, Optimal declared a $1.10 cash dividend. On December 31, which is
Verex’s year-end, the market value of the shares was $9.80 per share. On February 1, 2021,
Verex sold 50% of the investment for $12 per share less brokerage fees of $580.
Required:
a. Does Verex follow ASPE or IFRS, and why?
b. Record all the relevant journal entries for Verex for this investment from purchase to sale.
EXERCISE 8–9
At December 31, 2020, the following information is reported for Jackson Enterprises Co.:
Net income $250,000

Investments in FVOCI – carrying value 320,000
Investments in FVOCI – fair value 350,000
Accumulated Other Comprehensive Income, Jan 1, 2020 15,000
Required: Calculate the Other Comprehensive Income (OCI) and total comprehensive income
for the year ending December 31, 2020, and the December 31, 2020 ending balance for the
Accumulated Other Comprehensive Income (AOCI). Ignore income taxes.
EXERCISE 8–10
On January 2, 2020, Bellevue Holdings Ltd. purchased 5%, 10-year bonds with a face value
of $200,000 at par. This investment is accounted for at amortized cost. On January 4, 2021,
the investee company was experiencing financial difficulties. As a result, Bellevue evaluated
the investment and determined the following:
• The present value of the cash flows using the current market rate was $195,000
• The present value of the cash flows using the original effective interest rate was $190,000
By June 30, 2021, the investee recovered from the financial difficulties and was no longer
considered impaired.
Required: Record all the impairment related transactions in 2020 and 2021 assuming Bellevue
uses ASPE.
EXERCISE 8–11
On December 31, 2020, Camille Co. provided the following information as at December 31,
2020 about its investment accounts that it acquired for trading purposes:
Carrying Amount Fair Value

ABC Ltd. shares $15,000 $17,500
Warbler Corp. shares 24,300 22,500
Shickter Ltd. Shares 75,000 80,200
During 2021, Warbler Corp. shares were sold for $23,000 and 50% of the Shickter shares were
sold for $42,000. At the end of 2021, the fair value of ABC shares was $19,200 and Shickter
Ltd. was $41,000. Camille follows IFRS.
Required:
a. Prepare the adjusting entry for December 31, 2020, if any.
b. Prepare the entry for the Warbler and Shickter sales.
c. Prepare the adjusting entry for December 31, 2021, if any.
d. How would the entries in parts (a), (b), and (c) differ if Camille accounted followed ASPE?
EXERCISE 8–12
On September 30, 2019, FacePlant Inc. purchased a $225,000 face-value bond for par plus
accrued interest. The bond pays interest each October 31 at 4%. Management’s investment
business model is to hold for trading purposes. On December 31, 2019, the company year-
end, the fair value published for bonds of similar characteristics and risk was 102.6. On March
1, 2020, FacePlant sold the bonds for 102.8 plus accrued interest. FacePlant follows IFRS.
Required:
a. Prepare all the related journal entries for this investment. The company wants to report
interest income separately from other gains and losses.
b. Prepare a partial classified balance sheet and income statement for FacePlant, as at
December 31, 2019.
Exercises 331
c. How would the answer to parts (a) and (b) change if FacePlant followed ASPE?
d. What kinds of returns did this investment generate? (Hint: Consider all sources, such as
interest income and gain/loss on sale of the investment.)
EXERCISE 8–13
Bremblay Ltd. owns corporate bonds that it accounts for using the amortized cost model. As
at December 31, 2020, after an impairment review was triggered, the bonds have the following
financial data:
Par value $500,000
Amortized cost 422,000
Discounted cash flow at the current market rate 400,000
Discounted cash flows at the original historic rate 390,000
Bond, net realizable value 395,000
The company does not use a valuation account.
Required:
a. Prepare all relevant entries related to the impairment assuming the company follows
ASPE. Is this reversible?
b. Prepare all relevant entries related to the impairment assuming that the company follows
ASPE but uses an asset valuation allowance account.
EXERCISE 8–14
On January 1, 2020, Helsinky Co. paid cash to acquire 8% bonds of Britanica Corp. with a
maturity value of $250,000, to mature January 1, 2028. The bonds provide a 9% yield and pay
interest each December 31. Helsinky purchased these bonds as part of its trading portfolio
and accounts for the bonds as FVNI investments. On December 31, 2020, the bonds had a
fair value of $240,000. Helsinky follows ASPE and has a December 31 year-end.
During 2021, the industry sector that Britanica operates in experienced some difficult times
due to the drop in international market prices for oil and gas. As a result, by December 31,
2021, their debt was downgraded to the market price of 87.3. By December 31, 2022, the
bond had a market price of 92.3. In 2023, conditions improved measurably, resulting in the
bonds having a fair value on December 31, 2023 of 99.3.
Required:
a. Prepare all of the relevant entries for 2020, 2021, 2022 and 2023, including any adjusting
entries as required. Round entry amounts to the nearest whole dollar.
b. If Helsinky had accounted for the investment at amortized cost, identify and describe the
impairment model that the company would have used.
EXERCISE 8–15
On January 1, 2014, Billings Ltd. purchased 2,500 shares of Outlander Holdings for $87,500.
During the time that this investment has been held by Billings, the economy and the investee
company Outlander have experienced many good and bad times. In 2020, Outlander stated
that it was experiencing a reduction in profits but was trying to get things to improve.
Required:
a. Assume that Billings applies the cost method to this investment because there is no
active market for Outlander shares. In 2019, Billings had a general sense that the value
of its investment in Outlander had probably dropped by about 8.6% to $80,000. This was
not enough to trigger an impairment evaluation as it was still uncertain. By 2020, seeing
no improvement, Billings’ management completed an evaluation of the investment and
estimated that the discounted cash flows from this investment was now $50,000.
Prepare the entries for 2019 and 2020, assuming that Billings follows ASPE.
b. Next, assume that Billings classifies the investment as a FVNI. By the end of 2019, the
price of Outlander shares had fallen from $34.00 the previous year to $32.00. By 2020,
the price had dropped to a 52-week low of $25.00 per share.
Prepare the entries for 2019 and 2020, assuming that Billings follows ASPE.
c. Finally, assume that Billings follows IFRS and had purchased the shares of Outlander
because Billings wanted to collect the dividends and sell them to realize the change in
the shares’ valuation. For this reason, Billings classified the investment as a FVOCI
investment. How might the accounting treatment change due to a change to IFRS and
FVOCI?
EXERCISE 8–16
On January 1, 2020, Sandar Ltd. purchased 32% of Yarder Co.’s 50,000 outstanding common
shares at a price of $25 per share. This price is based on Yarder’s net assets. On June 30,
Yarder declared and paid a cash dividend of $60,000. On December 31, 2020, Yarder reported
net income of $120,000 for the year. At this time, the shares had a fair value of $23. Sandar’s
year-end is December 31 and follows ASPE.
Exercises 333
Required:
a. Assuming that Sandar does not have any significant influence over Yarder, prepare all
the 2020 entries relating to this investment using the FVNI classification.
b. Prepare all the 2020 entries relating to this investment if it was classified as cost due to
no active markets.
c. Prepare all the 2020 entries relating to this investment assuming that Sandar has signif-
icant influence over Yarder. Sandar uses the equity method of accounting.
EXERCISE 8–17
The following T-account shows various transactions using the equity method. This investment
of $290,000 is made up of 30% of the outstanding shares of another company who had a
carrying amount of $900,000. The excess of the purchase price over the investment amount
is attributable to capital assets in excess of the carrying values with the remainder allocated
to goodwill. The investor company has significant influence over the investee company. Divi-
dends for 15% of the investee’s net income are paid out in cash annually. The investee’s net
assets have a remaining useful life of 10 years. The investor company follows IFRS.
Investment in Investee Company

$290,000
60,000
9,000
1,500
Required:
a. What was the investee’s total net income for the year?
b. What was the investee’s total dividend payout for the year?
c. What is the investor’s share of net income?
d. How much was the investor’s annual depreciation of the excess payment for capital
assets?
e. How much of the excess payment would be assigned to goodwill?
f. How much are the investor’s share of dividends for the year?
EXERCISE 8–18
On January 1, 2019, Dologan Enterprises Ltd. purchased 30% of the common shares of
Twitterbug Inc. for $380,000. These shares are not traded in any active markets. The carrying
value of Twitterbug’s net assets at the time of the shares purchase was $1.2 million. Any
excess of the purchase cost over the investment is attributable to unrecorded intangibles with
a 10-year life.
During 2019, the following summary operations for Twitterbug occurred:
Net income and Total comprehensive income $ 50,000

Dividends paid 25,000
Investment fair value 400,000
During 2020, the following summary operations for Twitterbug occurred:
Net loss and Total comprehensive loss $ 15,000

Dividends paid 0
Investment fair value 360,000
Investment recoverable amount 370,000
Required:
a. Prepare all the relevant entries for 2019 and 2020 assuming no significant influence.
Assume that Dologan follows IFRS and accounts for the investment as a FVNI.
b. How is the comprehensive income affected in 2019 and 2020 in part (a)?
c. Prepare all the relevant entries for 2019 and 2020 assuming that Dologan can exercise
significant influence. Assume that Dologan follows IFRS.
d. Calculate the carrying value of the investment as at December 31, 2020 assuming
Dologan can exercise significant influence and follows IFRS.
e. How would your answer to part (c) be different if Twitterbug’s statement of comprehensive
income included a loss from discontinued operations of $15,000 (net of tax) for 2019?
EXERCISE 8–19
On January 1, 2020, Chacha Holdings Ltd., a privately-held corporation that follows ASPE,
purchased 35% of the common shares of Eugene Corp. for $600,000. With this purchase,
Exercises 335
Chacha now has significant influence over Eugene, who is a supplier of materials for Chacha’s
production processes. Below is some information about the investee at the date the shares
were purchased:
Carrying value of assets subject to amortization $ 900,000

Carrying value of assets not subject to amortization
(10 years useful life remaining, on a straight-line basis) 780,000
Fair value of the assets subject to amortization 1,050,000
Liabilities 225,000
Required: Prepare all relevant entries for the investment based on the information provided
above. Subsequently, the investee reported net income of $225,000 and dividends paid of
$100,000. Assume that any excess of payment that is unexplained is attributed to goodwill.
EXERCISE 8–20
Below are details for several independent investments:
i. Preferred shares were purchased from a publicly traded company because of their favourable
dividend payout history. They are for sale, but management has no specific intention to
sell at this time.
ii. On February 1, 2020, 10% or 1,400 shares of the total outstanding shares were pur-
chased from another company that is a privately-held corporation. Management intends
to acquire 30% of the total outstanding shares.
iii. The company has an investment in 10-year bonds which will mature in 5 more years.
Management’s intention was to hold them until maturity but the company is short of
cash, so a possibility exists that they may be sold in 2020, though that is not certain at
this point.
iv. Common shares of a supplier company were purchased to strengthen their relationship.
Management intends to hold this investment into the future.
v. On January 1, 2020, a 4% bond that will mature in 6 years was purchased at market price
of 92. When the price point reaches 103, management intends to sell the investment.
vi. Bonds that mature in 10 years were purchased with monies set aside for a new building
purchase expected to occur in 10 years. The bonds will be sold once they mature.
vii. On March 1, 2020, bonds maturing in 2021 were purchased.
Required:
a. What classification would each investment item be if the investor company follows APSE?
How are impairments treated from an accounting perspective?
b. What classification would each investment item be if the investor company follows IFRS?
EXERCISE 8–21
On January 1, 2020, Amev Ltd., an IFRS company, acquires a 3%, 5-year, bond at par for
$1,150,000, which it intends to hold and collect the contractual cash flows of principal and
interest. At year-end, management has determined that there is no significant increase in
credit risk, but there is a 1% chance that the company will not collect 15% of the bond face
value in the next 12 months.
Required: Determine the investment’s classification and prepare the year-end journal entry.
What is the carrying value of the bond?
EXERCISE 8–22
Referring to the data in Exercise 8–21, assume now that management estimates that there
has been a significant increase in the credit risk and there is now a 6% chance that the Amev
will not collect 50% of the bond face value over its life.
Required: Prepare the year-end entry and determine the carrying value of the investment.
What else has changed since the previous ECL valuation?
EXERCISE 8–23
Referring to the data in Exercise 8–21, prepare the year-end entry assuming that Amev
classifies the investment as FVOCI and the fair value of the bond at year-end was 99.5,
assuming the probabilities have not changed and there has been no significant change in
credit risk.
Chapter 9
Property, Plant, and Equipment
Winter in Hawaii!
In July 2014, WestJet Airlines Ltd. (WestJet) announced that it planned to purchase four
Boeing 767-300ERW aircraft to continue and enhance its service from Alberta to Hawaii.
These flights had previously been offered through an arrangement with another airline.
This represented a significant investment by the company, as each Boeing 767 sells for
approximately $191 million. The company had previously announced in March 2014 that it
had placed an order for an additional five Bombardier Q400 NextGen aircraft. Aside from
these orders, the company had also taken delivery of five other Q400 NextGen aircraft and
two Boeing 737NG 800s in the first half of 2014. The company’s total fleet of aircraft in
mid-2014 was 120 units, but the company indicated that it planned to expand the fleet to
approximately 200 units by 2027.
Clearly, aircraft equipment is a significant asset for an airline. In WestJet’s case, the total
carrying value of all its property and equipment at June 30, 2014 was approximately $2.7
billion. This represented approximately 66% of the company’s total asset base. The bulk
of the company’s investment in equipment was comprised of aircraft ($1.9 billion) and
deposits on aircraft ($0.5 billion). For any financial statement reader or decision maker, it
is important to gain a clear understanding of the nature of this significant asset class in
WestJet.
WestJet reports that their aircraft equipment is actually comprised of several compo-
nents. These components include the aircraft itself—the engine, airframe, and landing
gear components—and the live satellite television equipment. Each component is depre-
ciated over different periods of time, ranging from five to twenty years. In addition to the
aircraft equipment, the company depreciates other property and equipment, such spare
engines, ground property, buildings, and leasehold improvements over periods ranging
from three to forty years. It is evident that understanding the nature and identification of
components is an important accounting function in a company like WestJet.
In the company’s accounting policy note, it is stated that the identification of components
is based on management’s judgment of what constitutes a significant cost in relation to
the total cost of an asset. As well, it states that management considers the patterns of
consumption and useful lives of the assets when identifying reportable components. The
accounting policy note further states that most overhaul expenditures are capitalized and
depreciated.
As WestJet continues to expand its fleet into new types of aircraft, it will be important for
337
338 Property, Plant, and Equipment
management to consider their accounting policies carefully with respect to their property
and equipment. With such a significant investment in non-current assets, accounting
decisions regarding the identification of asset components can have a profound effect on
reported income. A sound understanding of the criteria and principles behind capitalization
of property, plant, and equipment assets is essential to understanding WestJet.
(Sources: Barterm, 2014; Westjet, 2014)
LO 1: Describe the characteristics of property, plant, and equipment assets that distinguish
them from other assets.
LO 2: Identify the criteria for recognizing property, plant, and equipment assets.
LO 3: Determine the costs to include in the measurement of property, plant, and equipment
at acquisition.
LO 4: Determine the cost of a property, plant, and equipment asset when the asset is
acquired through a lump-sum purchase, a deferred payment, or a non-monetary ex-
change.
LO 5: Identify the effect of government grants in determining the cost of a property, plant,
and equipment asset.
LO 6: Determine the cost of a self-constructed asset, including treatment of related interest

charges.
LO 7: Identify the accounting treatment for asset retirement obligation.
LO 8: Apply the cost model.
LO 9: Apply the revaluation model.
LO 10: Apply the fair value model.
LO 11: Explain and apply the accounting treatment for post-acquisition costs related to prop-
erty, plant, and equipment assets.
LO 12: Identify key differences between IFRS and ASPE.

Introduction 339
Introduction
The rapid development of information technology in recent decades has highlighted the im-
portance of intellectual capital. The future of commerce, we are told, lies in the development
of ideas, processes, and brands. Yet, even with this change in focus from a traditional man-
ufacturing economy, the importance of the physical assets of a business cannot be ignored.
Even companies like Facebook and Google still need computers to run their applications,
desks and chairs for staff to sit in, or buildings to house their operations. And even as the
knowledge economy grows, there continues to be an increasing variety of consumer products
being manufactured and sold. All of this activity requires capacity, and this capacity is provided
by the property, plant, and equipment of a business.
Self-Constructed Assets
1.0 Definition
Borrowing Costs
2.0 Recognition Asset Retirement

Obligations
3.0 Measurement
Lump Sum Purchases
at Recognition
Nonmonetary Exchanges
Property, Plant,
and Equipment
Deferred Payments
Government Grants
Cost Model
4.0 Measurement After

Initial Recognition Revaluation Model
Fair Value Model

5.0 Costs Incurred
After Acquisition
6.0 IFRS/ASPE
Key Differences
9.1 Definition
The computers, furniture, buildings, land, factory equipment, and so forth that a business owns
are called its hard assets, also sometimes referred to as fixed assets or capital assets. But
the term that is consistently used in the IFRS publications is property, plant, and equipment
(PPE).
According to IAS 16.6, under IFRS property, plant, and equipment are the tangible items that
are:
9.2. Recognition 341
• held for use in the production or supply of goods or services, for rental to others, or for
administrative purposes
• expected to be used during more than one period (IAS, 2003a)
A key element of the definition is that the item be tangible. This means that it must have
a physical substance; therefore, it does not include items of an intangible nature, such as a
copyright. The intended use of the asset is also important, as it is expected that it be used
for some productive purpose and not simply resold to a customer. This distinction of intent
is important. An automobile held by a car dealership would be considered inventory, as the
dealership intended to resell it; whereas, an automobile owned by a rental company would
be considered PPE, as the intended use is earning revenue from rentals. The definition also
suggests that the asset should be useful to the business for more than one accounting period.
Although this means that a tangible, productive asset with a useful life of two years would be
considered PPE, many PPE items have lives much longer than this. A property that includes
land and a manufacturing facility could be useful to a business for thirty or forty years, or even
longer. The long-term, productive assets of a business are sometimes referred to as bricks
and mortar, suggesting something of the relatively permanent nature of these assets.
9.2 Recognition
According to IAS 16.7, a PPE item should be recognized when:
• It is probable that future economic benefits associated with the item will flow to the entity.
• The item’s cost can be measured reliably (IAS 2003a).
Notice that these conditions are similar to our basic definition of an asset. Also notice that the
definition is phrased in terms of economic benefits, rather than of the item itself. This means
that some expenditures not directly incurred to purchase the asset, but necessary nonetheless
to guarantee the continued productive use of the asset, may still be included in the asset’s cost.
For example, safety equipment mandated by legislation may not provide direct revenue to the
business, but is necessary in order to continue operating the equipment legally. Thus, these
costs should be capitalized as part of the asset’s cost, and if significant, may even be identified
as a separate component of the asset.
The definition of PPE does not contain any guidance on how to define an individual element of
PPE. This means that the accountant will need to apply professional judgment to determine the
segregation of various PPE components. If we consider a large, complex piece of equipment
such as an airplane, the need for proper component accounting becomes clear. An airplane
contains several major elements: the fuselage, the engines, and the interior fixtures (seats,
galley, and so on). As indicated in the opening story about WestJet, each of these elements
may have a significantly different useful life, and may require maintenance and replacement
at different intervals. Because we need to depreciate assets based on their useful lives,
and because we need to consider the accounting treatment of subsequent expenditures,
it is important to define the separate components of a PPE item properly at the time of
recognition. Accountants will usually consider the value of the component relative to the
whole asset, along with the useful life and other qualitative and practical factors when making
these determinations.
IAS 16 also indicates that spare parts, stand-by equipment, and servicing equipment should be
recognized as property, plant, and equipment if they meet the definition. If they don’t meet the
definition, then it is more appropriate to classify these items as inventory. This is an area where
materiality and the accountant’s professional judgment will come into play, as the capitalization
of these items may not always be practical.
9.3 Measurement at Recognition
PPE assets are initially measured at their cost, which is the cash or fair value of other assets
given to acquire the asset. A few key inclusions and exclusions need to be considered in this
definition.
Any cost required to purchase the asset and bring it to its location of operation should be
capitalized. As well, any further costs required to prepare the asset for its intended use should
also be capitalized. The following is a list of some of the costs that should be included in the
capitalized amount:
• Purchase price, including all non-recoverable tax and duties, net of discounts
• Delivery and handling
• Direct employee labour costs to construct or acquire the asset
• Site preparation
• Other installation costs
• Net material and labour costs required to test the asset for proper functionality
• Professional fees directly attributable to the purchase
• Estimates of decommissioning and site restoration costs

9.3. Measurement at Recognition 343
Costs that should not be included in the initial capitalized amount include:
• Initial operating losses
• Training costs for employees
• Costs of opening a new facility
• Costs of introducing a new product or service
• Costs of reorganization and operation at a new location
• Administration and general overhead costs
• Other revenue or expenses that are incidental to the development of the PPE
9.3.1 Self-Constructed Assets
When a company chooses to build its own PPE, further accounting problems may arise.
Without a transaction with an external party, the cost of the asset may not be clear. Although
the direct materials and labour needed to construct the asset are usually easy to identify, the
costs of overheads and other indirect elements may be more difficult to apply. The general
rule to apply here is that only costs directly attributable to the construction of the asset should
be capitalized. This means that any allocation of general overheads or other indirect costs is
not appropriate. As well, any internal profits or abnormal costs, such as material wastage, are
excluded from the capitalized amount.
9.3.2 Borrowing Costs
One particular problem that arises when a company constructs its own PPE is how to treat any
interest incurred during the construction phase. IAS 23 (IAS, 2007) requires that any interest
that is directly attributable to the construction of a qualifying asset be capitalized. A qualifying
asset is any asset that takes a substantial amount of time to be prepared for its intended use.
This definition could thus include inventories as well as PPE, although the standard does not
require capitalization of interest for inventory items that are produced in large quantities on a
regular basis.
If a PPE asset is qualified under this definition, then a further question arises as to how much
interest should be capitalized. The general rule is that any interest that could have been
avoided by not constructing the asset should be capitalized. If the company has obtained
specific financing for the project, then the direct interest costs should be easy to identify.
However, note that any interest revenue earned on excess funds that are invested during
the construction process should be deducted from the total amount capitalized.
If the project is financed from general borrowings and not a specific loan, identification of the
capitalized interest is more complicated. The general approach here is to apply a weighted
average cost of borrowing to the total project cost and capitalize this amount. Some judgment
will be required to determine this weighted average cost in large, complex organizations.
Interest capitalization should commence when the company first incurs expenditures for the
asset, first incurs borrowing costs, and first undertakes activities necessary to prepare the
asset for its intended use. Interest capitalization should cease once substantially all of the
activities necessary to get the asset ready for its intended use are complete. Interest cap-
italization should also be stopped if active development of the project is suspended for an
extended period of time.
Many aspects of the accounting standards for interest capitalization require professional judg-
ment, and accountants will need to be careful in applying this standard.
9.3.3 Asset Retirement Obligations
For certain types of PPE assets, the company may have an obligation to dismantle, clean up,
or restore the site of the asset once its useful life has been consumed. An example would be
a drilling site for an oil exploration company. Once the well has finished extracting the oil from
the reserve, local authorities may require the company to remove the asset and restore the site
to a natural state. Even if there is no legal requirement to do so, the company may still have
created an expectation that it will do so through its own policies and previous conduct. This
type of non-legally binding commitment is referred to as a constructive obligation. Where
these types of legal and constructive obligations exist, the company is required to report a
liability on the balance sheet equal to the present value of these future costs, with the offsetting
debit being record as part of the capital cost of the asset. This topic will be covered in more
detail in Chapter 10, but for now, just be aware that this type of cost will be capitalized as part
of the PPE asset cost.
9.3.4 Lump Sum Purchases
There are instances where a business may purchase a group of PPE assets for a single price.
This is referred to as a lump sum, or basket, purchase. When this occurs, the accounting issue
is how to allocate the purchase price to the individual components purchased. The normal
practice is to allocate the purchase price based on the relative fair value of each component.
Of course, this requires that information about the assets’ fair values be available and reliable.
Often, insurance appraisals, property tax assessments, depreciated replacement costs, and
other appraisals can be used. The reliability and suitability of the source used will be a matter
of judgment on the part of the accountant.
Consider the following example. A company purchases land and building together for a total
price of $850,000. The most recent property tax assessment from the local government
indicated that the building’s assessed value was $600,000 and the land’s assessed value was
$150,000. The total purchase price of the components would be allocated as follows:
150,000×850,000
Land = $170,000
(150,000+600,000)
600,000×850,000
Building = $680,000
(150,000+600,000)
Total = $850,000
9.3.5 Non-monetary Exchanges
When PPE assets are acquired through payments other than cash, the question that arises is
how to value the transaction. Two particular types of transactions can occur: 1) a company
can acquire a PPE asset by issuing its own shares, or 2) a company can acquire a PPE asset
by exchanging it with another asset the company currently owns.
Asset Acquired by Issuing Shares
When a company issues its own shares to acquire an asset, the transaction should be recorded
at the fair value of the asset acquired. IFRS presumes that this fair value should normally
be obtainable. This makes sense, as it unlikely that a company would acquire an asset
without having a reasonable estimate of its value. If the fair value of the asset acquired is
not determinable, then the asset should be reported at the fair value of the shares given up.
This value is relatively easy to determine for an actively traded public company. In cases where
neither the value of the asset nor the value of the shares can be reliably determined, the asset
could not be recorded.
Asset Acquired in Exchange for Other Assets
When assets are acquired though exchange with other non-monetary assets or a combination
of monetary and non-monetary assets, the asset acquired should be valued at the fair value of
the assets given up. If this value cannot be reliably determined, then the fair value of the asset
received should be used. Notice how this differs from the rule for share-based payments. The
presumption is that the fair values of assets are generally more reliable than the fair values of
shares.
The implication of this general rule is that when non-monetary assets are exchanged, there
will likely be a gain or loss recorded on the transaction, as fair values and carrying values are
usually not the same. The recognition of a gain or loss suggests that the earnings process is
complete for this asset. This seems reasonable, as each company involved in the transaction
would normally expect to receive some economic benefit from the exchange.
There are two instances, however, where the general rule does not apply. These two situations
occur when:
• The fair values of both assets are not reliably measurable.
• The transaction lacks commercial substance.
Although it is an unusual situation, it is possible that the fair value of neither asset can be
reliably determined. In this case, the asset acquired would be recorded at the book value of
the asset given up. This means that no gain or loss would be recorded on the transaction.
A more likely situation occurs when the transaction lacks commercial substance. This means
that after the exchange of the assets, the company’s economic position has not been altered
significantly. This condition can usually be determined by considering the future cash flows
resulting from the exchange. If the business is not expected to realize any difference in the
amount, timing, or risk of future cash flows, either directly or indirectly, then there is no real
change in its economic position. In this case, it would be unreasonable to recognize a gain, as
there has been no completion of the earnings process. This type of situation could occur, for
example, when two companies want to change their strategic directions, so they swap similar
assets that may be located in different markets. There may be no significant difference in cash
flows, but the assets received by each company are more suitable to their long-term plans. In
this case, the asset acquired is reported at the carrying value of the asset given up.
One instance where accountants need to be careful occurs when an asset exchange lacks
commercial substance and the carrying amount of the asset given up is greater than the
fair value of the asset acquired. If we apply the principle for non-commercial exchanges by
recording the asset acquired at the carrying value of the asset given up, the result will be an
asset reported at an amount greater than its fair value. This result would create a misleading
statement of financial position, so in this case, the asset acquired should be reported at its
fair value, even though there is no commercial substance. This will result in a loss on the
exchange.
Consider the following illustrations of asset exchanges.
Commercial Substance
ComLink Ltd. decides to change its manufacturing process in order to accommodate a new
product that will be introduced next year. They have decided to trade a factory machine that is
no longer used in their production for a new machine that will be used to make the new product.
The machine that is being disposed of had an original cost of $78,000 and accumulated de-
preciation of $60,000. The fair value of the old machine at the time of exchange was $22,000.
The new machine being obtained has a list price of $61,000. After a period of negotiation,
the seller finally agreed to sell the new machine to ComLink Ltd. for cash of $33,000 plus the
trade-in of the old machine. As the new machine will be used to manufacture a new product
for the company, and the old machine was essentially obsolete, we can reasonably conclude
that this transaction has commercial substance. In this case, the journal entry to record the
exchange will be:
General Journal
New machine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,000
Accumulated depreciation – old machine . . . . . . 60,000
Old machine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,000
Gain on disposal of machine . . . . . . . . . . . . . . . 4,000
For New machine: ($22,000 + $33,000)
Note that the new machine is reported at the fair value of the assets given up in the exchange
($33,000 cash + $22,000 machine). Also note that the gain on the disposal is equal to the
fair value of the old machine ($22,000) less the carrying value of the machine at disposal
($78,000 − $60,000 = $18,000).
No Commercial Substance
Assume that ComLink Ltd. has a delivery truck that it purchased one year ago for $32,000.
Depreciation of $5,000 has been recorded to date on this asset. The company decides to trade
this for a new delivery truck in a different colour. The new truck has the same functionality and
expected life as the old truck. The only difference is the colour, which the company feels ties in
better with its corporate branding efforts. No identifiable cash flows can be associated with the
effect of this branding. The fair value of the old truck at the time of the trade was $28,000. The
seller of the new truck agrees to take the old truck in trade, but requires ComLink Ltd. to pay
an additional $5,000 in cash. In this instance, because there is no discernible effect on future
cash flows, we would reasonably conclude that the transaction lacks commercial substance.
The journal entry to record this transaction would be:
General Journal
New truck . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000
Accumulated depreciation – old truck . . . . . . . . . . 5,000
Old truck . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
For New truck: ($27,000 + $5,000)
Note that the new truck is reported at the book value of the assets given up ($5,000 cash +
($32,000 − $5,000) = $27,000 truck). Also note that the implied fair value of the new truck
($28,000 + $5,000 = $33,000) is not reported, and no gain on the transaction is realized.
If the same exchange occurred, but we were able to ascertain that the fair value of the asset
acquired was only $30,000, it would be inappropriate to record the new asset at a value of
$32,000, as this would exceed the fair value. The journal entry would thus be:
General Journal
New truck . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000
Accumulated depreciation – old truck . . . . . . . . . . 5,000
Old truck . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Loss on disposal of truck . . . . . . . . . . . . . . . . . . . . . . 2,000
Note that the new truck is recorded at the lesser of its fair value and the book value of the
asset given up. This results in a loss on the transaction, even though the transaction lacks
commercial substance.
9.3.6 Deferred Payments
When a PPE asset is purchased through the use of long-term financing arrangements, the
asset should initially be recorded at the present value of the obligation. This technique es-
sentially removes the interest component from the ultimate payment, resulting in a recorded
amount that should be equivalent to the fair value of the asset. (Note, however, that interest on
self-constructed assets, covered in IAS 23 and discussed previously in this chapter, is included
in the cost of the asset.) Normally, the present value would be discounted using the interest
rate stated in the loan agreement. However, some contracts may not state an interest rate or
may use an unreasonably low interest rate. In these cases, we need to estimate an interest
rate that would be charged by arm’s length parties in similar circumstances. This rate would be
based on current market conditions, the credit-worthiness of the customer, and other relevant
factors.
Consider the following example. ComLink Ltd. purchases a new machine for its factory. The
supplier agrees to terms that allow ComLink Ltd. to pay for the asset in four annual instalments
of $7,500 each, to be paid at the end of each year. ComLink Ltd. issues a $30,000, non-
interest bearing note to the supplier. The market rate of interest for similar arrangements
between arm’s length parties is 8%. ComLink Ltd. will record the initial purchase of the asset
as follows:
General Journal
Factory machine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,841
Note payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,841
The capitalized amount of $24,841 represents the present value of an ordinary annuity of
$7,500 for four years at an interest rate of 8%. The difference between the capitalized amount
and the total payments of $30,000 represents the amount of interest expense that will be
recognized over the term of the note.
9.3.7 Government Grants
Governments will at times create programs that provide direct assistance to businesses. These
programs may be designed to create employment in a certain geographic area, to develop
research and economic growth in a certain industry sector, or other reasons that promote the
policies of the government. When governments provide direct grants to businesses, there are
a number of accounting issues that need to be considered.
IAS 20 states that government grants should be “recognized in profit or loss on a systematic
basis over the periods in which the entity recognizes as expenses the related costs for which
the grants are intended to compensate” (IAS 20-12, IAS, 1983). This type of accounting is
referred to as the income approach to government grants, and is considered the appropriate
treatment because the contribution is coming from an entity other than the owner of the
business.
If the grant is received in respect of current operating expenses, then the accounting is quite
straightforward. The grant would either be reported as other income on the statement of profit
or loss, or the grant would be offset against the expenses for which the grant is intended
to compensate. When the grant is received to assist in the purchase of PPE assets, the
accounting is slightly more complicated. In this case, the company can defer the grant income,
reporting it as a liability, and then recognize the income on a systematic basis over the useful
life of the asset. Alternately, the company could simply use the grant funds received to offset
the initial cost of the asset. In this method, the grant is implicitly recognized through the
reduced depreciation charge over the life of the asset.
Consider the following example. ComLink Ltd. purchases a new factory machine for $100,000.
This machine will help the company manufacture a new, energy-saving product. The company
receives a government grant of $20,000 to help offset the cost of the machine. The machine is
expected to have a five-year useful life with no residual value. The accounting entries for this
machine would look like this:
Deferral Method Offset Method

Debit Credit Debit Credit
Machine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 80,000
Deferred grant . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 -
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,00 80,000
Purchase of machine.
Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 16,000

Accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 16,000
Deferred grant . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 -
Grant income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 -
First year depreciation and revenue recognition.
For Depreciation expense, deferral method: ($100,000 ÷ 5 years =
$20,000); offset method: ($80,000 ÷ 5 years = $16,000)
For Deferred grant: ($20,000 ÷ 5 years = $4,000)
The net effect on income of either method is the same. The difference is only in the presenta-
tion of the grant amount. Under the deferral method, the deferred grant amount presented on
the balance sheet as a liability would need to be segregated between current and non-current
portions.
Companies may choose either method to account for grant income. However, significant
note disclosures of the terms and accounting methods used for grants are required to ensure
comparability of financial statements.
9.4 Measurement After Initial Recognition
Once a PPE asset has been recognized and recorded, there are three choices in IFRS of how
to deal with the asset in subsequent accounting periods. The asset may be accounted for
using the cost model, the revaluation model, or the fair value model. Each of these models
treats subsequent changes in the value of the asset differently. When a model is chosen, it
must be applied consistently to all the assets in a particular class.
9.4.1 Cost Model
The cost model is considered the more established or traditional method of accounting for PPE
assets. This model measures the asset after its acquisition at its cost, less any accumulated
depreciation or accumulated impairment losses. The model, thus, does not attempt to adjust
the asset to its current value, except in the case of impairment. This means that changes in
the value of the asset are not recognized in income until that value is actually realized through
9.4. Measurement After Initial Recognition 351
the sale of the asset. This model is widely used and is very easy to understand and apply.
Depreciation and impairment will be discussed in a later chapter.
9.4.2 Revaluation Model
IFRS allows an alternative method for subsequent reporting of PPE assets. The revaluation
model attempts to capture changes in an asset’s value over its life. An essential condition of
using this model is that the fair value of an asset be available and reliable at the reporting
date. Fair values can often be determined through the use of qualified appraisers or other
professionals who understand how to interpret market conditions. If appraisals are not avail-
able, other valuation techniques may be used to estimate the value. However, in some cases
reliable fair values will not be available, so the model cannot be used.
The standard does not require that revaluations be performed at each reporting date, but it
does require that the reported value not be materially different from the current fair value at
the reporting date. If the property, plant, and equipment asset is expected to have volatile and
significant changes in value, then annual revaluations are required. If the asset is only subject
to insignificant changes in fair value each year, then revaluations every three to five years are
recommended. The costs of obtaining valuation data or appraisals are likely one reason this
method is not used by many companies. There is an additional cost in obtaining the reliable
fair values, which many companies would compare to the marginal benefit of adjusting the
PPE amounts on the balance sheet. In many cases, the fair values and depreciated costs of
PPE assets would not be significantly different, so the model would not be applied. For some
types of assets such as real estate, however, the revaluation model may provide significantly
different results than the cost model. In these instances, the use of the revaluation model has
a stronger justification.
In applying the revaluation model, adjustments are made to the PPE asset value by either
adjusting the cost and accumulated depreciation proportionally, or by eliminating the accumu-
lated depreciation and adjusting the asset cost to the new value. The second approach is
simpler to apply, and will be used in the illustrations below.
When adjusting the value of the PPE asset, the obvious question is how to treat the offsetting
side of the journal entry. The answer is to use an account called Revaluation Surplus, which
is reported as part of other comprehensive income. However, there are some complicating
factors in using this account.
If the adjustment increases the reported value, then report as part of revaluation surplus. If the
adjustment decreases the reported value, then first reduce any existing revaluation surplus for
that asset to zero, and record the remaining reduction as an expense in profit or loss. This
expense may be reversed in future periods, if the value once again rises.
Consider the following example to illustrate this model. ComLink Ltd. purchases a factory
building on January 1, 2019, for $500,000. The building is expected to have a useful life of
twenty years with no residual value. The company uses the revaluation model for this class of
asset and will obtain current valuations every two years. The journal entries for the first two
years would be:
General Journal
Jan 1 2019 Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000
Dec 31 2019 Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . 25,000

Accumulated depreciation . . . . . . . . . . . . . . . . . . 25,000
(($500,000 − 0) ÷ 20 years)

On December 31, 2020, an appraisal on the building is conducted and its fair value is deter-
mined to be $490,000. The following adjustment, which eliminates accumulated depreciation
and adjusts the asset’s cost to its new value, will be required:
General Journal
Dec 31 2020 Accumulated depreciation . . . . . . . . . . . . . . . . . . . . . 50,000
Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
($25,000 × 2 years)
Dec 31 2020 Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000

Revaluation surplus (OCI) . . . . . . . . . . . . . . . . . . 40,000
(($490,000 − ($500,000 − $50,000))
The cost of the building is now $490,000 and the accumulated depreciation is $nil. Because
the building has now been revalued, we need to revise the depreciation calculation. Assuming
no change in the remaining useful life of the asset, the new depreciation rate will be $490,000
÷ 18 years = $27,222. The journal entries for the next two years will be:
General Journal
On December 31, 2022, the building is again appraised, and this time the fair value is deter-
mined to be $390,000. The following journal entries will be required:
9.4. Measurement After Initial Recognition 353
General Journal
Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54,444
Dec 31 2022 Revaluation surplus (OCI) . . . . . . . . . . . . . . . . . . . . . 40,000

Revaluation loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,556
Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45,556
For Building: $390,000 − ($490,000 − (2 yrs ×
$27,222))
The revaluation loss of $5,556 will be reported on the income statement in the current year. In
future years, if the value of the building increases again, a revaluation gain can be reported on
the income statement up to this amount. Any further increases will once again increase the
Revaluation Surplus account.
The Revaluation Surplus (OCI) account itself can be dealt with in two ways. It can simply
continue to be reported as part of accumulated other comprehensive income for the life of
the asset. Once the asset is disposed of, the balance of the account is transferred from
Accumulated Other Comprehensive Income directly to retained earnings. Another option is
to make an annual transfer from the revaluation surplus account to retained earnings. The
amount that can be transferred is limited to the difference between the depreciation expense
that is actually recorded (using the revalued carrying amount) and the amount that would have
been recorded had the cost model been used instead.
9.4.3 Fair Value Model
The fair value model is a specialized type of optional accounting treatment that may be applied
to only one type of asset: investment properties. IAS 40 (IAS, 2003b) considers investment
properties to be land or buildings that are held primarily for the purpose of earning rental
income or capital appreciation, are not used for production or administrative purposes of the
business, and are not held for resale in the ordinary course of business. This definition sug-
gests that the asset will earn cash flows that are largely independent of the regular operations
of the business, which is why a different accounting standard can be applied. The fair value
model requires adjustment of the carrying value of the investment property to its fair value
every reporting period. As well, no depreciation is recorded for investment properties under
the fair value model. The key feature that differentiates this model from the revaluation model
is that gains and losses in value with investment properties are reported directly on the income
statement, rather than using a Revaluation Surplus (OCI) account. This can be illustrated with
the following example.
ComLink Ltd. purchases a vacant piece of land that it feels will appreciate in value over the
next ten years as a result of suburban expansion. The land is initially purchased for $5 million
on January 1, 2019. The company has classified this land as an investment property and has
chosen to use the fair value model. The appraised values of the land over the next three years
are:
Appraisal Date Appraised Value

December 31, 2019 $5,200,000
December 31, 2020 $4,600,000
December 31, 2021 $4,850,000
The adjustments will be recorded each year as follows:
General Journal
Dec 31 2019 Investment property . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000
Gain in value of investment property . . . . . . . 200,000
($5.2M − $5M)
Dec 31 2020 Loss in value of investment property . . . . . . . . . . . 600,000

Investment property . . . . . . . . . . . . . . . . . . . . . . . . 600,000
($4.6M − $5.2M)

($4.85M − $4.6M)
It should be noted that this model is optional for reporting purposes. A company may choose
to use the cost model for its investment properties. However, if the fair value model is chosen,
all investment properties must be reported this way. As well, there are significant disclosure
requirements under this model.
9.5 Costs Incurred After Acquisition
Costs to operate and maintain a PPE asset are rarely ever captured completely by the initial
purchase price. After a PPE asset is acquired, it is quite likely that there will be additional
costs incurred over time to maintain or improve the asset. The essential accounting question
that needs to be answered here is whether these costs should be recognized immediately
as an expense, or whether they should be capitalized and depreciated in future periods.
IAS 16 indicates that costs incurred in the day-to-day servicing of a PPE asset should not
be capitalized, as they do not meet the recognition criteria (i.e., they do not provide future
economic benefits). The types of costs discussed in the standard include labour, consumables,
and small parts. Immediately expensing these types of costs recognizes the fact that normal
9.5. Costs Incurred After Acquisition 355
repair and maintenance activities do not significantly extend the useful life of an asset, nor do
they improve the function of the asset. Rather, they simply maintain the existing capacity. As
such, they should be recognized as period costs.
Sometimes, a major component of a PPE asset may require periodic replacement. For exam-
ple, the motor of a transport truck may need replacement after operating for a certain number
of hours. Or, a restaurant may choose to knock down its existing walls to reconfigure and
redecorate the space to create a fresher image. If the business managers think these changes
create the potential for future economic benefits, then capitalization would be appropriate.
When these types of items are capitalized, they are actually replacing an existing component
of a PPE asset. In these cases, the old component needs to be removed from the carrying
value of the asset before the new addition is capitalized. This procedure is required, even if
the part being replaced was not actually recorded as a separate component. If this is the case,
the standard allows for a reasonable estimate to be made of the asset’s carrying value.
Consider the following example. LeCorre, a Michelin-starred restaurant, has recently decided
to update its image through a complete renovation of the dining room. This process involved
tearing out all the existing fixtures and relocating several walls. None of the fixtures or walls
were reported as separate components, as they were merely included as part of the original
building cost when it was purchased five years ago. The building has been depreciated on a
straight-line basis over an estimated useful life of thirty years. The total cost of the renovation
was $87,000, and the company received an additional $2,000 from the sale of the old fixtures.
It was also determined that construction costs in this area have increased by approximately
30% over the last five years.
The journal entries to record this renovation will be separated into two parts: the disposal of
the old assets and the purchase of the new assets.
1. Disposal of old assets
General Journal
Accumulated depreciation – building . . . . . . . . . . . 11,154
Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66,923
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Loss on disposal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53,769
If we assume that the old fixtures and decorations are of a similar quality as the new
ones, then the construction cost of the new renovations can be used to estimate the cost
of the assets that have been removed. With an increase in construction costs of 30%
over five years, the original cost can be estimated to be $87,000 × 1 ÷(1 + .3) = $66,923.
If the asset has been depreciated for five years, then the accumulated depreciation would
be ($66,923 ÷ 30) × 5 = $11,154. The loss on disposal equals the difference between
the calculated, net carrying value and the proceeds received.
2. Purchase of the new assets
General Journal
Building improvements . . . . . . . . . . . . . . . . . . . . . . . . 87,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87,000
If the management of LeCorre believes that these types of interior renovations will con-
tinue in the future at similar intervals, it should record the cost as a separate component,
as the useful life would clearly differ from the building itself.
Note that if the original renovations had already been recorded as a separate component, the
journal entries would take the same form, but there would be no need to estimate the cost and
book value of the original assets, as they would be evident from the accounting records.
IFRS ASPE
Component accounting is required. An item Significant and separable component parts
of PPE is defined by the economic benefits should be recorded as individual assets
that are derived from it, not the physical where practicable. In practice, this definition
nature of the item. has led to less components being reported
under ASPE than IFRS.
Any revenue and expense incurred prior to Any revenue or expense from using an item
the PPE asset being ready to use is taken to of PPE prior to its substantial completion is
profit or loss, as this is considered incidental included in the asset’s cost. Expenses are
to the construction of the asset. added to the asset cost while revenues are
deducted from the asset cost.
Borrowing costs directly attributable to PPE Directly attributable Interest costs may be
acquisition, construction, or development capitalized if this is the company’s chosen
must be capitalized. accounting policy.
The cost of legal and constructive obliga- Only legal obligations for asset retirement
tions for asset retirement must be capital- need to be capitalized.
ized.
PPE items can be accounted for using the Only the cost model may be used for PPE.
cost or the revaluation models.
Investment properties can be accounted for No separate standard for investment proper-
using the cost or fair value models. ties. They fall under the same general rule
(i.e., the cost model) as other types of PPE.
IAS 16.19 (IAS, 2003a) prohibits the inclu- S 3061.08 allows directly attributable over-
sion of general overhead costs in the capital head costs to be included in the capital
cost of a property, plant, and equipment cost of self-constructed property, plant, and
asset. equipment assets.
Chapter Summary 357
The general capitalization criterion requires S 3061.14 allows for the capitalization of
the presence of future economic benefits betterments. Betterments are costs incurred
flowing to the entity. However, IAS 16.20 to improve the service capacity, extend the
(IAS, 2003a) prohibits the capitalization of useful life, improve the quantity or quality of
redeployment, relocation, or reorganization output, or reduce the operating costs of a
costs. This excludes the capitalization of property, plant, and equipment asset.
some of the items that could be classified as
betterments under ASPE.
Chapter Summary
LO 1: Describe the characteristics of property, plant, and equipment assets that

distinguish them from other assets.
PPE assets are tangible items that are held for use in the production or supply of goods and
services, for rental to others, or for administrative purposes. It is presumed that they are
expected to be used for more than one period. The distinguishing features are in their nature
(they are tangible) and in their use (production, rather than resale).
LO 2: Identify the criteria for recognizing property, plant, and equipment assets.
PPE assets should be recognized when it is probable that future economic benefits associated
with the item will flow to the entity and the item’s cost can be measured reliably. As the
definition of PPE does not identify what specific, physical element should be measured, it is
important for accountants to apply good judgment in identifying the specific components of an
asset that need to be reported separately.
LO 3: Determine the costs to include in the measurement of property, plant, and

equipment at acquisition.
PPE costs should include any cost required to purchase the asset and bring it to its intended
location of use. As well, any further costs incurred to prepare the asset for its intended use
should also be capitalized.
LO 4: Determine the cost of a property, plant, and equipment asset when the asset
is acquired through a lump-sum purchase, a deferred payment, or a non-monetary
exchange.
When an asset is acquired through a lump-sum exchange, the purchase price should be
allocated based on the relative fair value of each asset acquired. When an asset is acquired
through a deferred payment, the asset cost should be recorded at the present value of the
future payments, discounted at either the interest rate implicit in the contract, or at a reasonable
market rate if the contract does not include a reasonable interest rate. When a PPE asset is
obtained through the issuance of the company’s own shares, the asset should be recorded at
its fair value. When a PPE asset is obtained by exchange with another, non-monetary asset
of the company, the new asset should be reported at the fair value of the assets given up.
However, if the fair values are not reliably measurable, or if the transaction lacks commercial
substance, then the new asset should be recorded at the carrying value of the assets given
up. The only exception to this occurs when a transaction lacks commercial substance, but the
fair value of the asset acquired is less than the carrying value of the asset given up. In this
case, the transaction should be reported at the fair value of the asset acquired, in order to
avoid overstating the value of the new asset.
LO 5: Identify the effect of government grants in determining the cost of a

property, plant, and equipment asset.
IAS 20 says that, “Government grants [should be recognized] in profit or loss on a systematic
basis over the periods in which the entity recognizes as expenses the related costs for which
the grants are intended to compensate.” In the case of grants received to assist in the purchase
of PPE assets, the grant can either be deducted from the initial cost of the asset, which will
reduce future depreciation, or the grant can be deferred and amortized into income on the
same basis as the asset’s depreciation. The net effect on income of these two methods will be
exactly the same.
LO 6: Determine the cost of a self-constructed asset, including treatment of

related interest charges.
For self-constructed assets reported under IFRS, only direct costs, and not overheads, should
be allocated to the PPE asset. When borrowing is incurred to construct an asset over a
substantial amount of time, any interest that is directly attributable to the construction should
be included in the asset cost.
Chapter Summary 359
LO 7: Identify the accounting treatment for asset retirement obligation.
When the company has a legal or constructive obligation to dismantle, clean up, or restore the
asset site at the end of its useful life, the present value of those asset retirement costs should
be included in the capital cost of the asset.
LO 8: Apply the cost model.
Under this model, PPE assets are reported at their acquisition cost, less any accumulated
depreciation. No attempt is made to adjust the value to reflect current market conditions.
LO 9: Apply the revaluation model.
Under this model, PPE assets may be adjusted to their fair values on a periodic basis, as-
suming the fair values are both available and reliable. Increases in value are credited to the
other comprehensive income account titled revaluation surplus. If the increase reverses a
previous decrease that was expensed, the increase should be reported as part of profit or
loss. Decreases in value are applied to first reduce any existing revaluation surplus, and then
reported as expense, if any balance remains. Adjustments to the asset value can be made
either by eliminating the accumulated depreciation and adjusting the asset cost, or by adjusting
the asset cost and accumulated depreciation proportionally.
LO 10: Apply the fair value model.
This model can only be used for investment properties, which are land and buildings held
primarily for the purpose of earning rental income or capital appreciation. With this model, the
carrying value of the investment property is adjusted to its fair value every reporting period.
Any gains and losses resulting from the revaluation are reported directly in profit or loss. As
well, no depreciation is reported on investment properties under this model.
LO 11: Explain and apply the accounting treatment for post-acquisition costs
related to property, plant, and equipment assets.
Costs incurred after acquisition can either be expensed immediately or added to the carrying
value of the PPE asset. Costs incurred for the normal, day-to-day maintenance of PPE asset
are usually expensed, as these costs do not add to the service life or capacity of the asset.
Costs that improve the asset by increasing future economic benefits, either by extending the
useful life or improving the efficiency of operation, are usually capitalized. When a significant
component of the asset is replaced, the cost and accumulated depreciation of the old asset
should be removed and the cost of the new asset should be capitalized.
The concept of component accounting is not as explicitly articulated in ASPE. ASPE requires
revenues or expenses incurred prior to asset completion to be included in the asset cost,
whereas IFRS takes these items to profit or loss. IFRS requires capitalization of borrowing
costs, whereas ASPE leaves the choice to management. ASPE only requires capitalization of
legal obligations for asset retirement, whereas IFRS also includes constructive obligations as
well. ASPE does not allow the use of the revaluation model or the fair value model.
References
Bartrem, R. (2014, July 29). Adding four 767-300ERW aircraft to the WestJet fleet [Westjet
Web log message]. Retrieved from http://blog.westjet.com/adding-boeing-767-300-a
ircraft-fleet/
International Accounting Standards. (1983). IAS 20–Accounting for government grants and
disclosure of government assistance. Retrieved from http://www.iasplus.com/en/standa
rds/ias/ias20
International Accounting Standards. (2003a). IAS 16–Property, plant and equipment. Re-
trieved from http://www.iasplus.com/en/standards/ias/ias16
International Accounting Standards. (2003b). IAS 40–Investment property. Retrieved from ht

tp://www.iasplus.com/en/standards/ias/ias40
International Accounting Standards. (2007). IAS 23–Borrowing costs. Retrieved from http:/
/www.iasplus.com/en/standards/ias/ias23
WestJet. (2014). Management’s discussion and analysis of financial results for the three and
six months ended June 30, 2014. Retrieved from http://www.westjet.com/pdf/investor
Media/financialReports/WestJet-Second-Quarter-Report-2014.pdf
Exercises 361
Exercises
EXERCISE 9–1
Dixon Ltd. has recently purchased a piece of specialized manufacturing equipment. The
following costs were incurred when this equipment was installed in the company’s factory
facilities in 2020.
Cash price paid, net of $1,600 discount, including $3,900 of recoverable tax $ 82,300
Freight cost to ship equipment to factory 3,300
Direct employee wages to install equipment 5,600
External specialist technician needed to complete final installation 4,100
Repair costs during the first year of operations 1,700
Materials consumed in the testing process 2,200
Direct employee wages to test equipment 1,300
Costs of training employees to use the equipment 1,400
Overhead costs charged to the machine 5,300
Legal fees to draft the equipment purchase contract 2,400
Government grant received on purchase of the equipment (8,000)
Insurance costs during first year of operations 900
Required: Determine the total cost of the equipment purchased. If an item is not capitalized,
describe how it would be reported.
EXERCISE 9–2
Argyris Mining Inc. completed construction of a new silver mine in 2020. The cost of direct
materials for the construction was $2,200,000 and direct labour was $1,600,000. In addition,
the company allocated $250,000 of general overhead costs to the project. To finance the
project, the company obtained a loan of $3,000,000 from its bank. The loan funds were drawn
on February 1, 2020, and the mine was completed on November 1, 2020. The interest rate
on the loan was 8% p.a. During construction, excess funds from the loan were invested and
earned interest income of $30,000. The remainder of the funds needed for construction was
drawn from internal cash reserves in the company. The company has also publicly made a
commitment to clean up the site of the mine when the extraction operation is complete. It is
estimated that the mining of this particular seam will be completed in ten years, at which time
restoration costs of $100,000 will be incurred. The appropriate discount rate for this type of
expenditure is 10%.
Required: Determine the cost of the silver mine to be capitalized in 2020.
EXERCISE 9–3
Cheng Manufacturing Ltd. recently purchased a group of assets from a bankrupt company
during a liquidation auction. The total proceeds paid for the assets were $220,000 and included
a specialized lathe, a robotic assembly machine, a laser guided cutting machine, and a delivery
truck. To make the bid at the auction, the company hired a qualified equipment appraiser who
provided the following estimates of the fair value of the assets, based on their conditions,
productive capacities, and intended uses:
Specialized lathe $ 30,000

Robotic assembly machine $ 90,000
Laser guided cutting machine $110,000
Delivery truck $ 20,000
Required: Determine the cost of each asset to be capitalized on Cheng Manufacturing Ltd.’s
books.
EXERCISE 9–4
Prabhu Industries Ltd. recently exchanged a piece of manufacturing equipment for another
piece of equipment owned by Zhang Inc. Prabhu Industries was required to pay an amount of
cash to finalize the exchange. The following information is obtained regarding the exchange:
Prabhu Zhang
Equipment, at cost 25,000 21,000
Accumulated depreciation 10,000 8,000
Fair value of equipment 17,000 19,000
Cash paid 2,000
Required:
a. Prepare the journal entries required by each company to record the exchange, assuming
the exchange is considered to have commercial substance.
b. Repeat part (a) assuming the exchange does not have commercial substance.
c. Repeat part (b) assuming the accumulated depreciation recorded by Prabhu is only
$5,000 instead of $10,000.
EXERCISE 9–5
Lo-Dun Inc. is a publicly traded financial services company. The company recently acquired
two assets in the following transactions:
Exercises 363
Transaction 1: Lo-Dun acquired a new computer system to assist with its programmed trading
activities. The computer system had a list price of $85,000, but the salesperson indicated that
the price could likely be negotiated down to $80,000. After further negotiation, the company
acquired the asset by issuing 15,000 of its own common shares. At the time of the transaction,
the shares were actively trading at $5.25 per share.
Transaction 2: Lo-Dun acquired new office furniture by making a down payment of $5,000 and
issuing a non-interest bearing note with a face amount of $45,000. The note is due in one
year. The market rate of interest for similar transactions is 9%.
Required: Prepare the journal entries for Lo-Dun Inc. to record the transactions. Provide a
rationale for the amount recorded for each item.
EXERCISE 9–6
Pei Properties recently purchased a vacant office condo where it plans to operate an employment-
training centre. The total purchase price of the condo was $625,000 with an expected useful
life of 30 years with no residual value. The local government in this municipality was very
interested in this project, providing a grant of $90,000 for the purchase of the condo. The only
condition of the grant was that the employment-training centre be operated for a period of at
least five years. Pei Properties believes that this target can be achieved with the business plan
it has prepared.
Required:
a. Prepare the journal entry to record the purchase of the condo, assuming the company
uses the deferral method to record the government grant.
b. Repeat part (a) assuming the company uses the offset method to record the government
grant.
c. Determine the annual effect on the income statement for each of the above methods.
EXERCISE 9–7
Finucane Manufacturing Inc. owns a large factory building that it purchased in 2016. At the
time of purchase, the company decided to apply the revaluation model to the property; the first
revaluation occurred on December 31, 2018. On January 1, 2019, the recorded cost of the
building was $1,200,000, and the accumulated depreciation was nil, as the company applies
the revaluation model by eliminating accumulated depreciation. The balance in the revaluation
surplus account on January 1, 2019, was $150,000. As well, the company decided on this
date to obtain annual appraisals of the property in order to revalue it at every reporting period.
The appraised values obtained over the next three years were as follows:
Date Appraised Value

December 31, 2019 $1,250,000
December 31, 2020 $1,000,000
December 31, 2021 $1,150,000
Required: Prepare all the required journal entries for this property for the years ended Decem-
ber 31, 2019 to 2021. Assume that the building is depreciated on a straight-line basis over 30
years with no residual value. Also assume that the company does not make annual transfers
from the revaluation surplus account to retained earnings.
EXERCISE 9–8
Kappi Capital Inc. holds a number of investment properties that it accounts for under IAS 40
using the fair value method. The company purchased a new rental property on January 1,
2020, for $1,500,000. The appraised value on December 31, 2020, was $1,450,000 and the
appraised value on December 31, 2021, was $1,625,000.
Required: Prepare the adjusting journal entries for this property on December 31, 2020, and
December 31, 2021.
EXERCISE 9–9
Sun Systems Ltd. operates a manufacturing facility where specialized electronic components
are assembled for use in consumer products. The facility was purchased in 2014 for a cost
of $800,000, excluding the land component. At the time of purchase, it was believed that the
building would have a useful life of 40 years with no residual value. The company follows
the policy of recording a full year of depreciation in the year of an asset’s acquisition and no
depreciation in the year of an asset’s disposal. During 2020, the following transactions with
respect to the building occurred:
• Regular repairs to exterior stucco and mechanical systems were incurred at a total cost
of $32,000.
• In the middle of the year, the existing boiler system failed and required replacement. The
replacement cost of the new unit was $125,000. Management considers this to be a
major component of the building, but had not separately recorded the cost of the original
boiler, as it was included in the building purchase price. It is estimated inflation has
increased the cost of these types of units by 15% since 2014.
Exercises 365
• The entire building was repainted at a cost of $15,000 during the year. This did not
extend the useful life of the building, but improved its overall appearance.
• A major structural repair to the foundation was undertaken during the year. This repair
cost $87,000 and was expected to extend the useful life of the building by ten years over
the original estimate.
• A small fire in the staff kitchen caused damage that cost $5,000 to repair.
Required: Prepare the journal entries to record the transactions that occurred in 2020. As-
sume all transactions were settled in cash.
Chapter 10
Depreciation, Impairment, and Derecognition of
Property, Plant, and Equipment
The Limping Kangaroo
The year 2014 was tough for Qantas Airways Ltd. On August 28, the iconic Australian
airline announced that it would be reporting a net loss of AUD $2,843 million for the year
ended June 30, 2014. The most significant components included in this loss were two
asset-impairment charges: AUD $387 million for impairment of specific assets and AUD
$2.6 billion for impairment of the Qantas International cash-generating unit. The CEO,
in his annual report to shareholders, indicated that these write-downs were “required by
accounting standards.” The chairman of the board of directors indicated in his report
that the year was “challenging” and “unsatisfactory” but made no mention of the asset
write-downs. These non-cash, asset-impairment charges, which were charged primarily
to the aircraft and engines category, clearly had a significant impact on the company’s
financial results. The impairment of the cash-generating unit, in particular, was almost
solely responsible for the company’s net loss.
This asset-impairment charge arose as part of a restructuring plan within the business.
The company assessed the value in use of a particular group of assets, Qantas Interna-
tional, and determined that the current carrying value of these assets was overstated. The
value in use was determined by projecting future cash flows for this asset group and then
discounting these cash flows at a 10.5 percent interest rate. In projecting the cash flows,
assumptions were made about the growth rate of future revenues, fuel charges, currency
exchange rates, and many other factors.
The annual report explained that the impairment loss resulted from a situation where wide-
body aircraft were purchased at a time when the Australian dollar was weaker than the US
dollar. Although this may explain why the initial recorded value of these assets was higher,
it obscures reasons behind the current decline in the value in use.
Clearly, the economic benefits to be derived from these assets were no longer justified by
the initial purchase price. Companies purchase property, plant, and equipment assets with
the expectation of realizing economic benefits at least equal to the price paid. Accounting
standards need to be able to allocate these capital costs in a rational way so that they are
reflected in the accounting periods where the economic benefits are created. When these
estimates of benefit consumption are incorrect, write-downs such as those experienced by
Qantas are necessary. The CEO was correct in stating that accounting standards require
this treatment. (Qantas, 2014).
In this chapter, we will examine the details of the accounting treatment of the use and
consumption of property, plant, and equipment assets.
367
368 Depreciation, Impairment, and Derecognition of Property, Plant, and Equipment
LO 1: Identify the purpose of depreciation, and discuss the elements that are required to
calculate depreciation.
LO 2: Calculate depreciation using straight-line, diminishing-balance, and units-of-production

methods.
LO 3: Discuss the reasons for separate component accounting and the accounting problems
that may arise from this approach.
LO 4: Calculate depreciation when partial periods or changes in estimates are required.
LO 5: Discuss indicators of impairment and calculate the amount of impairment.
LO 6: Identify the criteria required to classify an asset as held for sale.
LO 7: Prepare journal entries for assets held for sale.
LO 8: Discuss other derecognition issues.
LO 9: Identify the presentation and disclosure requirements for property, plant, and equip-
ment.
Introduction
As we saw in the previous chapter, companies invest significant amounts of capital in property,
plant, and equipment (PPE) assets. The purpose of these investments is to gain productive
capacity that will further the goals of the business. The success of these investments in PPE
will be evaluated based on the productive capacity attained relative to the costs incurred. We
have already learned how to determine the costs to record for PPE assets. In this chapter, we
will examine how to record the use of PPE assets and how to deal with the eventual disposal
of these assets.
Depreciable Amount
Useful Life
1.0 Definition
Methods of Calculation
2.0 Depreciation
Calculations
Separate Components
Depreciation,
Impairment, and
Partial Period Calculations
Derecognition of PPE
Revision of Depreciation
Accounting for Impairment
3.0 Impairment
Cash-Generating Units
Held for Sale
4.0 Derecognition
Other Derecognition
Issues
5.0 Presentation
and Disclosure
6.0 IFRS/ASPE
Key Differences
A. ASPE Standards
for Impairment
10.1 Definition
IAS 16.50 indicates that the depreciable amount of an asset should be allocated on a system-
atic basis over its useful life. This description captures one of the key elements of depreciation
concept: it is an allocation of the asset’s cost.
Many people often associate the idea of depreciation with a decline in value of the asset.
Although it is possible that the depreciation calculated approximates the loss in value of the
asset as it is used, there is no guarantee that this will be true. It is important to appreciate
that the purpose of accounting depreciation is to match the initial cost of the PPE asset to the
periods that benefit from its use. Depreciation does not provide an estimate of the change in
an asset’s fair value. Rather, it simply provides a way to allocate asset costs to the correct
accounting periods.
The description above also identifies three key concepts:
• The depreciable amount
• The useful life of the asset
• The basis (method) used to calculate depreciation.
A further requirement of the standard is that significant components be depreciated separately.

We will deal with each of these elements separately.
10.2 Depreciation Calculations
10.2.1 Depreciable Amount
The first element that needs to be determined for a depreciation calculation is the depreciable
amount. It represents the cost that will be allocated to future periods through the depreciation
process. This amount is determined by taking the asset’s cost and deducting the residual
value. (Note: if the company uses the revaluation method, the cost is replaced by the revalued
amount in this calculation.) The residual value is the estimated net amount that the company
would be able to sell the asset for at the end of its useful life, based on current conditions.
Thus, the estimate does not try to anticipate future changes in market or economic conditions;
it merely considers the nature of the asset itself. The residual value is, of course, an estimate
and is thus subject to possible error. As a result, IFRS requires an annual review of residual
amounts used in depreciation calculations. If the residual amount needs to be changed, it
10.2. Depreciation Calculations 371
should be accounted for prospectively as a change in estimate. Many assets will have a
residual value of zero or close to zero, and this amount will thus be ignored in the calculation.
If the revised residual value were to exceed the carrying value of the asset, then depreciation
would cease until the residual value dropped back below the carrying value.
10.2.2 Useful Life
The useful life of an asset is determined by its utility to the company. This means that estimates
need to be made about how long the company plans to use the asset. For certain types of
assets, companies may have a policy of timed replacement, even if the asset is still functioning.
This means the useful life may be less than the physical life of the asset. IFRS (International
Accounting Standards, n.d., 16.56) identifies the following factors that need to be considered
in determining useful life to the company:
• The expected usage of the asset, as assessed by reference to the asset’s expected
capacity or physical output.
• The expected physical wear and tear, which depends on operational factors, such as the
number of shifts for which the asset is to be used, the repair and maintenance program,
and the care and maintenance of the asset while idle.
• The technical or commercial obsolescence of the asset arising from changes or im-
provements in production or from a change in the market demand for the product or
service output of the asset. Expected future reductions in the selling price of an item that
was produced using an asset could indicate the expectation of technical or commercial
obsolescence of the asset, which, in turn, might reflect a reduction of the future economic
benefits embodied in the asset.
• The legal or similar limits on the use of the asset, such as the expiry dates of related
leases.
It should be apparent that a substantial amount of judgment is required in determining the

useful life of an asset. Although management may have significant experience in working with
these assets, the estimation process can still result in errors. The process of annual review
and estimation changes for useful lives is the same as described above, in 10.2.1: Depreciable
Amount, for residual values.
Another question that needs to addressed when determining the useful life of an asset is when
to start and stop depreciating it. Depreciation of the asset should commence when the asset
is available for use. This means that the asset is in place and ready for productive function,
even if it is not actually being used yet. Depreciation should stop at the earlier date when the
asset is either reclassified as held for sale or derecognized. These situations will be covered
later in the chapter.
10.2.3 Methods of Calculation
The IFRS requirement of allocation of cost on a systematic basis is a deliberately vague

description of the techniques used to calculate depreciation. Companies are given the freedom
to choose the method used, as long as the method makes sense in relation to the consumption
of future economic benefits realized by use of the asset. The standard does identify three
broad techniques that can be used: straight line, diminishing balance, and units of production.
However, other techniques could be justified if they provide a more systematic and reasonable
allocation of cost. The standard also indicates that depreciation methods based on revenue
should not be used, as revenue may be affected by factors, such as inflation, that are not
directly related to the consumption of economic benefits.
Straight-Line Method
This is the simplest and most commonly used depreciation method. This method simply
allocates cost in equal proportions to the time periods of an asset’s useful life. The formula to
determine the depreciation charge is as follows:
Cost − Residual value

= Depreciation charge
Useful life
For example, consider an automated packaging machine purchased for $100,000 that is used
in a factory. It is estimated that this machine will have a useful life of ten years and will have a
residual value of $5,000. The calculation of the annual depreciation charge is as follows:
$100,000 − $5,000
= $9,500 per year
10 years
The benefit of this method is its simplicity for both the preparer and reader of the financial
statement. No special knowledge is required to understand the logic of the calculation. As
well, the method is appropriate if we assume that economic benefits are delivered in roughly
equal proportions over the life of the asset. However, there are arguments that are contrary
to this assumption. For certain assets, it may be reasonable to assume that the economic
benefits decline with the age of the asset, as there is more downtime due to repairs or other
operational inefficiencies that result from age. If these inefficiencies are significant, then the
straight-line method may not be the most appropriate method.
Diminishing-Balance Method
The diminishing-balance method results in more depreciation in the early years of an asset’s
life and less depreciation in later years. The justification for this method is that an asset
will offer its greatest service potential when it is relatively new. Once an asset ages and
starts to require more repairs, it will be less productive to the business. This reasoning is
quite consistent with the experience many companies have with assets that have mechanical
components. This method will also result in an overall expense to the company that is fairly
consistent over the life of the asset. In early years, depreciation charges are high, but repairs
are low; in later years, this situation will reverse.
A number of different calculations can be used when applying the diminishing-balance method.
The common feature of all the methods is that a constant percentage is applied to the closing
net book value of the asset each year to determine the depreciation charge. The percentage
that is used can be derived in a number of ways. The most accurate way would be to apply a
formula to determine the exact percentage needed to depreciate the asset down to its residual
value. Although this can be done, this approach is not often used, because it requires a more
complex calculation. A simpler, more commonly used approach is to simply use a multiple
based on the asset’s useful life. For example, a technique referred to as double-declining
balance would convert the useful life to a percentage and multiply the result by two. In our
previous example, the calculation would be as follows:
1
× 2 = Depreciation rate
Useful life
1
× 2 = 20%
10 years
Depreciation would thus be calculated as follows:
Year Book Value, Rate Depreciation Accumulated Book Value,

Opening Expense Depreciation Closing
1 100,000 20% 20,000 20,000 80,000
2 80,000 20% 16,000 36,000 64,000
3 64,000 20% 12,800 48,800 51,200
4 51,200 20% 10,240 59,040 40,960
5 40,960 20% 8.192 67,232 32,768
6 32,768 20% 6,554 73,786 26,214
7 26,214 20% 5,243 79,029 20,971
8 20,971 20% 4,194 83,223 16,777
9 16,777 20% 3,355 86,578 13,422
10 13,422 20% 8,422* 95,000 5,000
*Note: In the final year, depreciation does not equal the calculated amount of net book value
multiplied by depreciation percentage ($13,422 × 20% = $2,684). In the final year, the asset
needs to be depreciated down to its residual value. The double-declining balance method
will not result in precisely the right amount of depreciation being taken over the asset’s useful
life. This means that the final year’s depreciation will need to be adjusted to bring the net
book value to the residual value. Depending on the useful life of the asset, this final-year
depreciation amount may by higher or lower than the amount calculated by simply applying
the percentage. Because depreciation is an estimate based on a number of assumptions, this
type of adjustment in the final year is considered appropriate.
Also note that in the calculations above, unlike other methods, the residual value is not de-
ducted when determining the depreciation expense each year. The residual value is consid-
ered only when adjusting the final year’s depreciation expense.
Units-of-Production Method
This method is the most theoretically supportable method for certain types of assets. The
method charges depreciation on the basis of some measure of activity related to the asset.
The measures are often output based, such as units produced. They can also be input based,
such as machine hours used. Although output-based measures are the most accurate way to
reflect the consumption of economic benefits, input-based measures are also commonly used.
The benefit of this method is that it clearly links the actual usage of the asset to the expense
being charged, rather than simply reflect the passage of time. Returning to our example, if the
machine were expected to be able to package 1,000,000 boxes before requiring replacement,
our depreciation rate would be calculated as follows:
$100,000 − $5,000
= $0.095 per box
1,000,000 boxes
Thus, if in a given year, the machine actually processed 102,000 boxes, the depreciation
charge for that year would be as follows:
102,000 × $0.095 = $9,690
In years of high production, depreciation will increase; in years of low production, depreciation
will decrease. This is a reasonable result, as the costs are being matched to the benefits being
generated. However, this method is appropriate only where measures of usage are meaning-
ful. In some cases, assets cannot be easily measured by their use. An office building that
houses the corporate headquarters cannot be easily defined in terms of productive capacity.
For this type of asset, a time-based measure would make more sense.
10.2.4 Separate Components
As noted in Chapter 9, IFRS requires PPE assets be segregated into significant components.
One of the reasons for doing this is that a significant component of the asset may have a
different useful life than other parts of the asset. An airplane’s engine does not have the
same useful life as the fuselage. It makes sense to segregate these components and charge
depreciation separately, as this will provide a more accurate picture of the consumption of
economic benefits from the use of the asset.
The process of determining what comprises a component requires some judgment from man-
agers. A reasonable approach would be to first determine what constitutes a significant
component of the whole and then determine which components have similar characteristics
and patterns of use. Practical considerations, the availability of information, and cost versus
benefit analyses (related to accounting costs) may all be relevant in determining how finely
the components are defined. The goal is to create information that is meaningful for decision-
making purposes without being overly burdensome to the company.
10.2.5 Partial Period Calculations
In the year of acquisition or disposal of a PPE asset, an additional calculation complication

arises—namely, how to deal with depreciation for only part of a year. If the units-of-production
method is being used, this isn’t really a problem, as the depreciation will be based on the
actual production in the partial period. However, for time-based methods, like straight line or
diminishing balance, an adjustment to the calculation will be required.
Because accounting standards do not specify how to deal with this problem, companies
have adopted a number of different practices. Although depreciation could be prorated on
a daily basis, it is more usual to see companies prorate the calculation based on the nearest
whole month that the asset was being used in the accounting period. Some companies will
charge a full year of depreciation in the year of acquisition and none in the year of disposal,
while other companies will reverse this pattern. Some companies charge half the normal
rate in the years of acquisition and disposal. Whatever method is used, the total amount of
depreciation charged over the life of the asset will be the same. As long as the method is
applied consistently, there shouldn’t be material differences in the reported results.
10.2.6 Revision of Depreciation
As noted previously, many elements of the depreciation calculation are based on estimates.
IFRS requires that these estimates be reviewed on an annual basis for their reasonableness.
If it turns out that the original estimate is no longer appropriate, how should the depreciation
calculation be revised? The treatment of estimate changes requires prospective adjustment,
which means that current and future periods are adjusted for the effect of the change. No
adjustments should be made to depreciation amounts reported in prior periods. The reasoning
behind this treatment is that estimates, by their nature, are subject to inaccuracies. As well,
conditions may change; the asset may be used in a different fashion than originally intended,
or the asset may lose function quicker or slower than originally anticipated. As long as the
original estimate was reasonable in relation to the information available at the time, there is no
need to adjust prior periods once conditions change.
Consider our original example of straight-line depreciation. The initial calculation resulted in
an annual depreciation charge of $9,500. After two years of use, the company’s management
noticed that the asset’s condition was deteriorating quicker than expected. The useful life of
the asset was revised to seven years, and the residual value was reduced to $2,000. The
revision to the depreciation charge would be calculated as follows:
Remaining book value − Revised residual value

Remaining useful life
Thus, the calculation would be as follows:
$100,000 − ($9,500 × 2) − $2,000

= $15,800 per year
7 − 2 = 5 years remaining
The company would begin charging this amount in the third year and would not revise the pre-
vious depreciation that was recorded. This technique is also applied if the company changes
its method of depreciation, because it believes the new method better reflects the pattern of
use or benefits derived from the asset, or if improvements are made to the asset that add to
its capital cost.
10.3 Impairment
For a variety of reasons, a PPE asset may sometimes become fully or partially obsolete
to the business. If the value of the asset declines below its carrying value, the accounting
question is whether this decline in value should be recorded or not. For current assets such
as inventory, these types of declines in value are recorded so that a financial-statement reader
is not misled into thinking the current asset will generate more cash than is actually realizable.
This treatment is reasonable for a current asset, but should the same approach be used for
PPE assets?
Impairment of PPE asset values can result from many different circumstances. IAS 36 dis-
cusses the following possible signs of impairment:
External indicators
• include observable indications of decline in value;

10.3. Impairment 377
• include technological, market, economic, or legal changes that affect the asset or entity;
• include increases in interest rates that reduce the discounted value in use of the asset;
and
• mean that the carrying value of the entity’s net assets is greater than its market capital-
ization.
Internal indicators
• include obsolescence or physical damage;
• include significant changes in how the asset is used, such as excess capacity or plans
for early disposal of the asset; and
• mean that economic performance of asset is worse than expected, including the cash
needed to acquire and/or operate and maintain the asset.
These factors and other information will need to be considered carefully when reviewing for
impairment; judgment will need to be applied. The company should assess whether there is
any indication of asset impairment on an annual basis. If there is evidence of impairment,
then the company will need to determine the amount of the impairment and account for this
condition.
10.3.1 Accounting for Impairment
There is an assumption in the IFRS standards that an entity will act in a rational manner. This
means that if selling the asset rather using it can generate more economic benefit, it would
make sense to do so. To determine impairment, we need to compare the carrying value of the
asset with its recoverable amount.
The recoverable amount of an asset is defined as the greater of the asset’s value in use and
its fair value, less costs of disposal. The asset’s value in use is calculated as the present value
of all future cash flows related to the asset, assuming that it continues to be used. The fair
value less costs of disposal refers to the actual net amount that the asset could be sold for
based on current market conditions.
Consider the following example. During the annual review of asset impairment conditions,
a company’s management team decides that there is evidence of impairment of a particular
asset. This asset is recorded on the books with a cost of $30,000 and accumulated deprecia-
tion of $10,000. Management estimates and discounts future cash flows related to the asset
and determines the value in use to be $15,000. The company also seeks the advice of an
equipment appraiser who indicates that the asset would likely sell at an auction for $14,000,
less a 10 percent commission.
The recoverable amount of the asset is $15,000, as this value in use is greater than the fair
value less costs of disposal ($14,000 − $1,400 = $12,600). The carrying value is $20,000
($30,000 − $10,000). As the recoverable amount is less than the carrying value, the asset is
impaired. The following journal entry must be recorded to account for this condition:
General Journal
Loss on impairment . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Accumulated impairment loss . . . . . . . . . . . . . . 5,000
Although a separate accumulated impairment loss account has been credited here, it is com-
mon in practice to simply credit accumulated depreciation. The net result of these two ap-
proaches will be exactly the same. Also note that if the asset were accounted for using the
revaluation method, the impairment loss would first reduce any existing revaluation surplus
(OCI), with the remaining loss being charged to the income statement.
If, in the future, the recoverable amount increases so that the asset is no longer impaired, the
accumulated impairment loss can be reversed. However, the impairment loss can be reversed
only to the extent that the new carrying value does not exceed the depreciated carrying value
that would have existed had the impairment never occurred. Also note that in subsequent
years, depreciation calculations will be based on the revised carrying value.
A different method is used to determine impairment under ASPE. This method is described in
10.7 Appendix A.
10.3.2 Cash-Generating Units
The usual situation when applying an impairment test would be to make the assessments on
an asset-by-asset basis. However, in some circumstances, it may be impossible to determine
the impairment of an individual asset. Some assets may have a value in use only when used
in combination with other assets. Consider, for example, a petrochemical-processing plant.
The plant is engineered with many customized components that work together to process
and produce a final product. If any part of the plant were removed, the process could not
be completed. In this case, the cash flows derived from the use of the group of assets are
considered a single economic event. The cash flows from an individual asset component within
the group cannot be determined separately. In these cases, IAS 36 allows the impairment test
to be performed at the level of the cash-generating unit, rather than at the individual asset
level.
IAS 36 defines a cash-generating unit as “the smallest identifiable group of assets that gener-
10.3. Impairment 379
ates cash inflows that are largely independent of the cash inflows from other assets or groups
of assets” (International Accounting Standards, n.d., 36.68). The definition of cash-generating
units should be applied consistently from year to year. Obviously, significant judgment is
required in making these determinations.
The impairment test is applied the same way to cash-generating units as with individual assets.
The only difference is that any resulting impairment loss is allocated on a pro-rata basis to the
individual assets within the cash-generating unit, based on the relative carrying amounts of
those assets within the group. However, in this process, no individual asset should be reduced
below the greater of its recoverable amount or zero.
Consider the following example. A petrochemical-processing plant is composed of a number

of different assets, including the following:
Cost ($) Accumulated Carrying

Depreciation ($) Amount ($)
Pumps, tanks, and drums 390,000 210,000 180,000
Reactors 1,100,000 650,000 450,000
Pipes and fittings 275,000 155,000 120,000
Distillation column 850,000 465,000 385,000
2,615,000 1,480,000 1,135,000
Management considers this plant to be a cash-generating unit. Due to recent declines in

commodity prices, management believes the plant may be impaired. After some investiga-
tion, management determines that the distillation column could be sold for net proceeds of
$435,000. All the other assets, however, are integrated into the plant structure and could not
be sold separately. As well, due to local regulations, the plant cannot be sold in its entirety.
Management has projected that by operating the plant for the next three years, cash flows of
$1,200,000 could be generated. The present value of these cash flows is $950,000.
Impairment here is determined by comparing the carrying amount of $1,135,000 with the
recoverable amount of $950,000. The value in use is the appropriate measure here, as the fair
value less costs to sell of $435,000 is lower. In this case, there is an impairment of $185,000
($1,135,000−$950,000). None of the impairment should be allocated to the distillation column,
as the carrying value of $385,000 is already less than the recoverable amount of $435,000. For
the remaining components, we cannot determine the recoverable amount, so the impairment
loss will be allocated to these assets on a pro-rata basis.
Carrying Proportion Impairment

Amount ($) Loss ($)
Pumps, tanks, and drums 180,000 180/750 44,400
Reactors 450,000 450/750 111,000
Pipes and fittings 120,000 120/750 29,600
750,000 185,000
The journal entry would record separate accumulated-impairment loss amounts for each of
the above components.
10.4 Derecognition
At some point in a PPE asset’s life, it will be sold, disposed, abandoned, or otherwise removed
from use. The accounting treatment for these events will depend on the timing and nature of
the transactions.
10.4.1 Held for Sale
When management first makes the decision to sell a noncurrent asset rather than continue to
use it in operations, it should be reclassified as an asset that is held for sale. This is a class
of current assets that is disclosed separately from other assets. For an asset to be classified
as held for sale, the following conditions must be met:
• The asset must be available for immediate sale in its present condition, subject only to
terms that are usual and customary for sales of such assets.
• The sale must be highly probable.
• Management must be committed to a plan to sell the asset.
• There must be the initiation of an active program to locate a buyer and complete the
plan.
• The asking price must be reasonable in relation to the asset’s current fair value.
• The sale should be expected within one year of the decision, unless circumstances
beyond the entity’s control delay the sale.
• It is unlikely that the plan will be withdrawn.
There are a number of accounting issues with held-for-sale assets. First, the asset needs to
be revalued to the lower of its carrying value, or its fair value, less costs to sell. Because the
10.4. Derecognition 381
company expects to sell these assets in a short period of time, it is reasonable to report them
at an amount that is no greater than the amount of cash that can be realized from their sale.
Second, assets that are held for sale are no longer depreciated. This is reasonable, as these
assets by definition are available for immediate sale. This means that they are no longer being
used for productive purposes, so depreciating them would not be appropriate.
The result of the revaluation described above means that an impairment loss will occur if the
expected proceeds (fair value less costs to sell) are less than the carrying value. This loss
will be reported in the year that management makes the decision to sell the asset, even if the
asset is not actually sold by the year-end. The impairment loss will be reported in a manner
consistent with other impairment losses, as described in IAS 36. When the asset is actually
sold, the difference between the actual proceeds and the amount expected will be treated as
a gain or loss in that year, not as an increase or reversal of the previous impairment loss.
If, at the time of classification as held for sale, the expected proceeds are greater than the
carrying amount, this gain will not be reported until the asset is actually sold. This gain will
simply be reported as a gain consistent with the treatment of other gains.
Consider this example. A company purchases an asset for $100,000 in 2015 and decides in
late 2020 to sell the asset immediately. The accumulated depreciation at the time the decision
is made is $40,000. Management estimates that the asset can be sold for $50,000, less
disposal costs of $2,000. In 2020, when the decision to sell the asset is made, the following
journal entry will be required.
General Journal
Asset held for sale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48,000
Accumulated depreciation . . . . . . . . . . . . . . . . . . . . . 40,000
PPE asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
For Asset HFS: ($50,000 − $2,000)
In 2021, the asset is actually sold for net proceeds of $49,000. The journal entry to record this
transaction is as follows:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49,000
Asset held for sale . . . . . . . . . . . . . . . . . . . . . . . . . 48,000
Gain on sale of asset . . . . . . . . . . . . . . . . . . . . . . 1,000
Now, if in 2020, the amount management estimates the sales proceeds to be $65,000 instead
of $50,000, less costs to sell of $2,000, the journal entry would be as follows:
General Journal
PPE asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Note that we do not report the asset held for sale at its estimated realizable value ($65,000 −
$2,000 = $63,000), as this is greater than the carrying value. When the sale occurs in 2021,
the following journal entry would be required:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49,000
Loss on sale of asset . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000
As a practical matter, many companies may not immediately reclassify the asset as held for
sale, as they expect to sell it within the same accounting period, or they do not meet the strict
criteria for classification. If this occurs, then the disposal journal entry will simply remove the
carrying value of the asset, report the net proceeds received, and report a gain or loss on
disposal. This gain or loss will be reported on the income statement, but gains cannot be
classified as revenues.
10.4.2 Other Derecognition Issues
There are times when assets may be disposed of in ways other than by direct sale. For
example, an asset can be expropriated by a government agency that has the authority to do
so, with compensation being paid. Insurance proceeds may be received for an asset destroyed
in a fire. These types of transactions would be recorded much as a simple sale would be, with
a resulting gain or loss (the difference between the compensation received and the carrying
value of the assets) being reported on the income statement.
In other instances, a company may choose to simply abandon or scrap an asset for no
proceeds. If this occurs, the asset should be derecognized, and a loss equal to the carrying
value of the asset at the time of abandonment should be recognized.
A less common situation may occur when a business agrees to donate an asset to some other
entity. For example, a land-development company may donate a piece of land to a municipality
for use as a recreational space. The company may believe that this will help develop a positive
business relationship with the municipality and its citizens. With this type of transaction, the
fair value of the property needs to be determined. The disposal will then be recorded at this
value, which will result in expense being recorded equal to this fair value. The carrying value
10.5. Presentation and Disclosure Requirements 383
of the asset will also be derecognized, which will result in a gain or loss if the carrying value
differs from the fair value.
10.5 Presentation and Disclosure Requirements
IAS 16 details a number of required disclosures for property, plant, and equipment assets.
Some of these disclosures are as follows:
• The measurement bases used
• Depreciation methods used
• Useful life or depreciation rates used
• A reconciliation of the gross carrying amount and accumulated depreciation at the be-
ginning of the period to the amount at the end of the period, including
– details of revaluations and impairment losses, including an indication of whether an

independent appraiser was used;
– details of additions and disposals, including assets held for sale;
– the depreciation charged during the year; and
– the effect on PPE of exchange rate differences
• Restrictions on the use of the assets pledged as security for liabilities
• Commitments to purchase assets
• Any compensation received from third parties when assets are impaired or abandoned
• Details of the effects of changes in estimates.
The scope and scale of these disclosure requirements reflect the fact that property, plant, and
equipment assets are often a significant portion of a company’s total asset base. As well, they
reflect the variety of different methods and estimates required in accounting for PPE assets.
The significant disclosures should help readers better understand how a company uses its
assets to generate returns.
IFRS ASPE
The depreciable amount is calculated using The depreciable amount is calculated using
the asset’s residual value. the lesser of salvage value or residual value.
Salvage value is the estimated value of the
asset at the end of its physical life, rather
than its useful life.
The term used is depreciation. The term used is amortization.
Cost, revaluation, and fair-value models can Only the cost model is allowed.
be used.
Assessment for indications of impairment Impairment is tested only when circum-
should occur at least annually. stances indicate impairment may exist.
A one-step process to determine impair- A two-step process is used. Impairment
ment, based on comparing recoverable is tested first by comparing carrying value
amount with carrying amount, is used. Re- with undiscounted cash flows. If impaired,
coverable amount is the greater of value in the loss is determined by subtracting the
use or fair value less costs to sell. fair value from the carrying amount. See
10.7 Appendix A for details.
Impairment loss can be reversed when esti- Impairment loss cannot be reversed.
mates change. However, amount of reversal
may be limited.
Assets that meet the criteria of held for sale Assets held for sale can be classified as
are classified as current. current only if the asset is sold before
financial statements are completed.
More extensive disclosure requirements Fewer disclosure requirements must be met.
must be met.
10.7 Appendix A: ASPE Standards for Impairment
Under ASPE 3063, a different set of standards is applied to the issue of PPE impairment. The
basic premise underlying these principles is that an asset is impaired if its carrying value
cannot be recovered. Unlike IFRS, which requires annual impairment testing, the ASPE
standard requires only impairment testing when events or changes in circumstances indicate
that impairment may be present. Some of the possible indicators of an asset’s impairment
include the following:
• A significant decrease in its market price
• A significant adverse change in the extent or manner in which it is being used or in its
physical condition
10.7. Appendix A: ASPE Standards for Impairment 385
• A significant adverse change in legal factors or in the business climate that could affect
its value, including an adverse action or assessment by a regulator
• An accumulation of costs significantly in excess of the amount originally expected for its
acquisition or construction
• A current-period operating or cash flow loss combined with a history of operating or cash
flow losses or a projection or forecast that demonstrates continuing losses associated
with its use
• A current expectation that, more likely than not, it will be sold or otherwise disposed of
significantly before the end of its previously estimated useful life (“more likely than not”
means a level of likelihood that is more than 50 percent) (CPA Canada, 2016, 3063.10).
The accountant will need to apply judgment in assessing these criteria. Other factors could be
present that could indicate impairment.
Once the determination is made that impairment may be present, the accountant must follow
a two-step process:
1. Determine if the asset is, in fact, impaired.
2. Calculate and record the impairment loss.
Step 1 involves the application of a recoverability test. This test is applied by comparing the
predicted, undiscounted future cash flows from the asset’s use and ultimate disposal with the
carrying value of the asset. If the undiscounted future cash flows are less than the asset’s
carrying value, the asset is impaired. The calculation of the predicted, undiscounted cash
flows will be based primarily on the company’s own assessment of the possible uses of the
asset. However, the accountant will need to apply diligence in assessing the reasonableness
of these cash flow assumptions.
Step 2 involves a different calculation to then determine the impairment loss. The impairment
loss is the difference between the asset’s carrying value and its fair value. The fair value is
defined as “the amount of the consideration that would be agreed upon in an arm’s length
transaction between knowledgeable, willing parties who are under no compulsion to act”
(CPA Canada, 2016 3063.03b). Note that, unlike the IFRS calculation, disposal costs are
not considered. The fair value should always be less than the undiscounted cash flows, as
any knowledgeable party would discount the cash flows when determining an appropriate
value. The best evidence of fair value would be obtained from transactions conducted in active
markets. However, for some types of assets, active market data may not be available. In these
cases, other techniques and evidence will be required to determine the fair value.
The application of this standard can be best illustrated with an example. Consider a company
that believes a particular asset may be impaired, based on its current physical condition.
Management has estimated the future undiscounted cash flows from the use and eventual
sale of this asset to be $125,000. Recent market sales of similar assets have indicated a fair
value of $90,000. The asset is carried on the books at a cost of $200,000 less accumulated
depreciation of $85,000. In applying step 1, the recoverability test, management will compare
the undiscounted cash flows ($125,000) with the carrying value ($115,000). In this case,
because the undiscounted cash flows exceed the carrying value, no impairment is present,
and no further action is required.
If, however, the future, undiscounted cash flows were $110,000 instead of $125,000, the result
would be different:
Step 1: Future undiscounted cash flows $110,000

Carrying value $115,000
Difference $ (5,000)
Because this result is less than zero, the asset is impaired. The impairment loss must then be
calculated.
Step 2: Fair value $ 90,000

Carrying value $ 115,000
Impairment loss $(25,000)
This loss would be recorded as follows:
General Journal
Although a separate accumulated impairment loss account has been credited here, it is com-
mon in practice to simply credit accumulated depreciation. The net result of these two ap-
proaches will be the same.
The new carrying value for the asset after the impairment loss is recorded becomes the new
cost base for the asset. This result has two effects. First, the asset’s depreciation rate will
need to be recalculated to take into account the new cost base and any other changes that
may be relevant. Second, any subsequent change in circumstances that results in the asset
no longer being impaired cannot be recorded. Future impairment reversals are not allowed,
because we are creating a new cost base for the asset.
Chapter Summary 387
One conceptual problem with this approach is that the carrying value of the asset may not
always reflect the underlying economic value to the company. By not testing for impairment
every year, it is possible that an asset that is becoming impaired incrementally may not be
properly adjusted until the impairment is quite severe. Once the impairment is recorded, the
inability to reverse this amount if future circumstances improve means the asset’s economic
potential is not properly reflected on the balance sheet. Although there are problems with this
approach, it can be argued that annual impairment testing for all assets is a time-consuming
and costly exercise. Thus, the standard results in a trade-off between theoretical and practical
considerations. This is considered a reasonable trade-off for private enterprises, as they
usually have a much smaller group of potential financial-statement readers, as well as fewer
resources available to dedicate to accounting and reporting matters.
Chapter Summary
LO 1: Identify the purpose of depreciation, and discuss the elements that are
required to calculate depreciation.
Depreciation is a systematic allocation of an asset’s cost to the accounting periods in which

the benefits of the asset are consumed. Depreciation is not an attempt to revalue the asset.
To calculate depreciation, one needs to determine the depreciable amount, the useful life, and
method of calculation. The depreciable amount is the cost less the residual value. The useful
life of an asset will not necessarily be the same as the physical life of the asset. The method
should systematically allocate the cost in a manner that reflects the consumption of economic
benefits. Significant judgment will be required when applying these three elements.
LO 2: Calculate depreciation using straight-line, diminishing-balance, and

units-of-production methods.
Straight-line depreciation assumes that benefits are derived from the asset in equal propor-
tions over the asset’s life. The calculation divides the depreciable amount by the useful life and
then allocates this equal charge over the life of the asset. The diminishing-balance approach
assumes that greater benefits are derived earlier in an asset’s life. This approach charges
a constant percentage of the asset’s carrying value each year to depreciation. The units-
of-production method charges varying amounts of depreciation based on the asset’s activity.
Using output measures is more theoretically correct, but input measures may also be used.
The calculation requires dividing the depreciable amount by the expected amount of productive
output over the asset’s life and then applying the resulting rate to the actual production in the
reporting period.
LO 3: Discuss the reasons for separate component accounting and the accounting
problems that may arise from this approach.
Component accounting is required because significant asset components may have different
useful lives and different economic consumption patterns. By recording components sepa-
rately, accountants are able to create more meaningful depreciation calculations. Problems
that arise in this approach include the inability to measure component costs accurately, the
judgment required in identifying significant components, and the additional accounting costs
in maintaining component records.
LO 4: Calculate depreciation when partial periods or changes in estimates are

required.
The depreciation charge in the period in which an asset is purchased or sold will need to be
prorated based on time, except when using the units-of-production method. This proration
can be calculated a number of ways but should be consistent from period to period. When
changes in estimates regarding useful life, residual value, or pattern of consumption (method)
are determined, these changes should be treated prospectively. The new estimate is applied
to the current carrying amount, resulting a new depreciation charge for current and future
periods. No adjustments are made to past period-depreciation charges.
LO 5: Discuss indicators of impairment and calculate the amount of impairment.
Impairment is indicated when external factors related to the environment in which the business
operates or internal factors related to the asset itself indicate that the carrying value may
not be ultimately realized. External factors include observable indications of loss of value;
technological, market, or legal changes; increases in interest rates; and declines in market
capitalization. Internal factors include physical damage, changes in the use of the asset, and
declining productivity of the asset. Impairment is calculated as the difference between the
carrying amount and the recoverable amount. The recoverable amount is the greater of the
value in use or fair value, less costs of disposal. Impairment tests may sometimes be applied
to cash-generating units if the effects on individual assets cannot be determined.
LO 6: Identify the criteria required to classify an asset as held for sale.
For an asset to be classified as held for sale, a number of conditions must be present. The as-
set must be available for immediate sale, and the sale must be highly probable. Management
must be committed to the sale and must have an active program to locate a buyer. The asking
Chapter Summary 389
price must be reasonable in relation to the market. The sale should be expected within one
year, and it should be unlikely that the plan will be withdrawn.
LO 7: Prepare journal entries for assets held for sale.
When an asset is classified as held for sale, it must be revalued to the lower of its carrying
value or fair value less costs to sell. As well, depreciation of the asset will cease once it is
classified as held for sale. This treatment means that either no change in value will occur,
or an impairment loss will be reported in the year when the classification occurs. When the
asset is subsequently sold in a future period, the resulting gain or loss is not treated as an
impairment loss or reversal.
LO 8: Discuss other derecognition issues.
If an asset is expropriated or otherwise disposed, and proceeds are received, this transaction
is treated the same as any other asset disposal, with the resulting gain or loss being reported
on the income statement. If an asset is simply abandoned or scrapped, then that asset needs
to be derecognized, and a loss will be reported equal to the carrying value of the asset. When
an asset is donated, the asset needs to be derecognized, and an expense is recognized equal
to the fair value of the asset. This means a gain or loss will likely result on this transaction.
LO 9 Identify the presentation and disclosure requirements for property, plant,

and equipment.
IFRS requires a significant amount of disclosure regarding PPE assets. Some of these disclo-
sures include details of methods and assumptions that are used in depreciation calculations,
the measurement base used, reconciliation of changes during the period, restrictions on and
commitments for assets, details of any revaluations, details of changes in estimates, and other
factors.
IFRS and ASPE share many similarities in the treatment of PPE assets. Some differences
include the absence of fair value and revaluation methods under ASPE, a different test and
criteria for impairment, different classification rules for held-for-sale assets, different methods
of determining the depreciable amount, and greater disclosure requirements under IFRS.
References
CPA Canada. (2006) CPA Canada Handbook. Toronto, ON: CPA Canada.
International Accounting Standards (n.d.). In IAS Plus. Retrieved from http://www.iasplus

.com/en/standards/ias
Qantas. (2014). Qantas Airways and its controlled entities: Preliminary final report for the
financial year ended 30 June 2014. Retrieved from http://www.qantas.com.au/infodetai
l/about/investors/preliminaryFinalReport14.pdf
Exercises
EXERCISE 10–1
Machado Inc. purchased a new robotic drill for its assembly line operation. The total cost of
the asset was $125,000, including shipping, installation, and testing. The asset is expected to
have a useful life of five years and a residual value of $10,000. The total service life, expressed
in hours of operation, is 10,000 hours. The total output the machine is expected to produce
over its life is 1,000,000 units.
The asset was purchased on January 1, 2020, and it is now December 31, 2021. In 2021, the
asset was used for 2,150 hours and it produced 207,000 units.
Required: Calculate the 2021 depreciation charge using the following methods:
a. Straight-line
b. Activity, based on units of input
c. Activity, based on units of production
d. Double declining balance
EXERCISE 10–2
Cortazar Ltd. purchased a used delivery van for $10,000 on June 23, 2020. The van is
expected to last for three years and have a residual value of $1,000. The company’s year-
end is December 31, and it follows the policy of charging depreciation in partial periods to the
nearest whole month of use.
Exercises 391
Required: Calculate the annual depreciation charge and ending carrying value of the asset for
each of the following fiscal years using the straight-line method:
a. December 31, 2020
b. December 31, 2021
c. December 31, 2022
d. December 31, 2023
EXERCISE 10–3
Equipment purchased for $39,000 by Escarpit Inc. on January 1, 2018 was originally estimated
to have a five-year useful life with a residual value of $4,000. Depreciation has been recorded
for the last three years based on these factors. In 2021, the asset’s condition was reviewed,
and it was determined that the total useful life will likely be seven years and the residual value
$5,000. The company uses straight-line depreciation.
Required:
a. Prepare the journal entry to correct the prior years’ depreciation.
b. Prepare the journal entry to record the 2021 depreciation.
EXERCISE 10–4
Michaux Ltd. purchased an office building on January 1, 2006, for $450,000. At that time, it
was estimated that the building would last for 30 years and would have a residual value of
$90,000. Early in 2012, a significant modification was made to the roof of the building at a
cost of $30,000. This modification could not be identified as a separate component, but it was
believed that it would add an additional ten years to the useful life. As well, it was estimated the
residual value would be reduced to $50,000 at the end of the revised useful life. In 2020, due
to a collapse in the local property market, the residual value was revised to nil. The useful life,
however, was expected to remain as estimated in 2012. The company uses the straight-line
method of depreciation.
Required:
a. Calculate the annual depreciation that was charged from 2006 to 2011.
b. Calculate the annual depreciation that was charged from 2012 to 2019.
c. Calculate the annual depreciation that will be charged from 2020 onwards.
EXERCISE 10–5
In December 2020, the management of Bombal Inc. reviewed its property, plant, and equip-
ment and determined that one machine showed evidence of impairment. The following infor-
mation pertains to this machine:
Cost $325,000
Accumulated depreciation to date $175,000
Estimated future cash flows, undiscounted $140,000
Present value of estimated future cash flows $110,000
Fair value $125,000
Costs of disposal $ 9,000
Bombal Inc. intends to continue using the asset for the next three years, with no expected
residual value at the end of that period. Bombal uses straight-line depreciation.
Required:
a. Determine if the asset is impaired under IAS 36.
b. If impairment is indicated in part (a), prepare the necessary journal entry at December
31, 2020, to record the impairment.
c. Prepare the journal entry to record depreciation for 2021.
d. After recording the depreciation for 2021, management reassesses the asset and de-
termines that the fair value is now $120,000, the undiscounted future cash flows are
$110,000, and the present value of the estimated future cash flows is $90,000. There
was no change to the costs of disposal. Prepare the journal entry, if any, to record the
reversal of impairment.
EXERCISE 10–6
Repeat the requirements of the previous question, assuming the company reports under ASPE
3063.
EXERCISE 10–7
Exercises 393
Reyes Technologies Ltd. has defined its computer repair division as a cash-generating unit un-
der IFRS. The company reported the following carrying amounts for this division at December
31, 2020:
Computers $55,000
Furniture $27,000
Equipment $13,000
The computer repair division is being assessed for impairment. At December 31, 2020, the
division’s value in use is $80,000.
Required:
a. Determine if the computer repair division is impaired, assuming that none of the individ-
ual assets has a determinable recoverable amount.
b. Prepare the journal to record the impairment from part (a), if any.
c. Determine if the computer repair division is impaired, assuming that the computers
have a fair value less cost to sell of $60,000, but that none of the other assets have
a determinable recoverable amount.
d. Repeat part (c) assuming that the computers’ fair value less cost to sell is $50,000.
EXERCISE 10–8
Landolfi Inc. owns a property that has a carrying value on December 31, 2021, of $520,000
(cost $950,000, accumulated depreciation $430,000).
Required:
For each of the following independent situations, prepare the journal entry to record the
transaction. Assume that at no time prior to the transaction did the asset qualify as a held
for sale asset. All transactions occur on December 31, 2021.
a. The property was sold to Paz Inc. for $450,000.
b. The local government expropriated the property to provide land for an expansion of the
rapid rail transit line. Compensation of $750,000 was paid to Landolfi Inc.
c. Due to a toxic mould problem, the property was deemed unsafe for use and was aban-
doned. Management does not believe there is any possibility of selling the property or
recovering any amount from it.
d. Landolfi Inc. donated the property to the local government for use as a future school site.
At the time of the donation, the fair value of the property was $600,000.
EXERCISE 10–9
Schulz Ltd. purchased a machine in 2017 for $65,000. In late 2020, the company made a plan
to dispose of the machine. At that time, the accumulated depreciation was $25,000 and the
estimated fair value was $35,000. Estimated selling costs were $1,000. Assume that the asset
qualifies as a held for sale asset at December 31, 2020.
Required:
a. Prepare the journal entry required at December 31, 2020.
b. On March 3, 2021, the asset is sold for $37,000. Prepare the journal entry to record the
sale.
c. Repeat parts (a) and (b) assuming that the estimated fair value on December 31, 2020,
was $45,000 instead of $35,000.
Chapter 11
Intangible Assets and Goodwill
Tesla Patents to be Shared With Competitors
In an unprecedented move, Tesla announced in 2014 that it intended to share its significant
number of patents with all other companies making electric cars. This is a radical departure
from its previous strategy to apply for as many patents as possible considering its concern
that the big car companies would copy Tesla’s technology. Tesla would be no match for
these companies with their huge scale manufacturing facilities and their big budget sales
and marketing. As it turned out, Tesla’s fears about the big car companies copying Tesla’s
technology did not materialize because the electric vehicle market was not big enough to
make the effort.
Since then, a new movement called “open source” has been gaining prominence in to-
day’s business world. Since the focus of Tesla Motors was to accelerate the growth of
sustainable transport—including electric cars—it follows that they would change their phi-
losophy from holding patents to sharing their technology with other electric car companies.
Moreover, the global vehicle market has now reached about two billion cars, increasing the
carbon crises concern held by many. This environmental concern creates an opportunity
for the electric car industry sector to take a bigger slice of the car market, especially if like-
minded companies such as Tesla band together and share their technologies. This could
result in the development of a common technology platform that would further the sus-
tainable transport sector as a better environmental alternative compared to hydrocarbon-
based transportation, currently the focus of most big car companies.
(Source: Musk, 2014)
LO 1: Describe intangible assets and goodwill and their role in accounting and business.
LO 2: Describe intangible assets and explain how they are recognized and measured.
LO 2.1: Describe purchased intangibles and explain how they are initially measured.
LO 2.2: Describe internally developed intangibles and explain how they are initially mea-
sured.
395
396 Intangible Assets and Goodwill
LO 2.3: Describe how intangible assets are subsequently measured.

LO 2.4: Describe how intangible assets are evaluated for impairment and derecognized.
LO 3: Describe goodwill and explain how it is recognized and measured.
LO 4: Identify the disclosure requirements for intangible assets and goodwill.
LO 5: Describe how intangible assets and goodwill affect the analysis of company perfor-
mance.
LO 6: Explain the similarities and differences between ASPE and IFRS for recognition, mea-
surement, and reporting for intangible assets and goodwill.
Introduction
Why did Tesla purposely share its valuable and closely guarded patent secrets with its competi-
tor electric car manufacturers? As the covering story explains, their largest competition does
not come from within their own electric vehicle industry sector—it comes from the massive
hydrocarbon-operated (i.e., gasoline, diesel) car market. If Tesla shares its critical intellectual
property, such as its patents, with other electric car manufacturers at no cost, the electric
car industry sector could strengthen enough to cause a shift in consumers from hydrocarbon
vehicles to electric. In short, it is all about increasing the market share for electric cars. By
sharing these valuable intangible assets within their industry sector, it increases these odds
significantly.
Tesla thinks they can use their patents, which are some of Tesla’s intangible assets, to make
a difference and create a shift in demand from hydrocarbon to electric-powered vehicles. This
must mean that there is a tremendous value regarding Tesla’s patents. As intangibles assets,
how might Tesla account for these patents? This chapter look at intangible assets and goodwill
and how they impact business.
Like property, plant, and equipment (PPE) assets, intangible assets are long-lived, non-monetary
assets whose costs are capitalized and reported as long-term assets on the statement of
financial position/balance sheet (SFP/BS). But unlike PPE, intangible assets have no physical
presence. Patents and copyrights have often become the subject of news headlines when
competitor companies attempt to infringe upon them. Many costly and prolonged court battles
have occurred as a result. Significant value is associated with these intangible assets, so it is
critical that they be accounted for as realistically as possible.
11.1. Intangible Assets and Goodwill: Overview 397
This chapter will focus on the various kinds of intangible assets and goodwill in terms of their
use in business, as well as their recognition, measurement, reporting, and analysis.
1.0 Intangible Assets

Purchased Intangible
and Goodwill: Overview
Assets
2.0 Intangible Assets: Internally Developed

Initial Recognition Intangible Assets
and Measurement
Intangible Assets:
Intangible Assets Intangible Assets: Impairment

and Goodwill and Derecognition
Initial Recognition
and Measurement
3.0 Goodwill
4.0 Disclosures of Intangible
Assets and Goodwill
5.0 Analysis
6.0 IFRS/ASPE
Key Differences
11.1 Intangible Assets and Goodwill: Overview
Consider how important video game developers such as BioWare, the creators of Dragon Age,
have become in this decade with their mass-market appeal for gaming software. Their major
long-term assets are not physical assets as is the case with other companies that own mainly
property, plant, and equipment. Instead, their assets are the software and the unique software
development teams who are inspired and talented enough to create gaming products that are
successfully marketed to millions of people around the world. Software gaming programs are
copyrighted, just like published books. The copyright may have no physical presence but it has
value, as will now be discussed.
In terms of accounting for intangible assets, IFRS, IAS 38 Intangible Assets (IFRS, 2014)
defines these as meeting three conditions:
• identifiable, non-monetary asset without physical substance
• controllable by the business (by purchase or internally created)
• from which future benefits are expected to occur.
Identifiable, in this case, means either being separable (can be sold, transferred, rented, or
exchanged) or arising from contractual or other legally enforceable rights. Intangible assets
are non-monetary assets because they have inherent values based on their use in business.
Cash, on the other hand, is a monetary asset because its value is based on what it represents
since the paper the cash is printed on has very little value by itself, as was discussed in the
cash and receivables chapter.
Intangible assets are not to be confused with goodwill. If BioWare was to sell their entire
business to a third party for more than the sum of the fair values of their identifiable assets
net of liabilities (net identifiable assets), then the excess amount of the fair value of the
consideration paid over the net identifiable assets by the purchaser would be classified as
goodwill. The additional amount that the purchaser is willing to pay may be due to a brilliantly
creative software development team with extraordinary talents that has value to the purchaser.
Even though goodwill is inherently part of the purchase and has no physical presence, it is not
classified as an intangible asset. This is because it is not separately identifiable from the other
assets, nor does it have any contractual or other legally enforceable rights. For this reason,
it does not meet the definition of an intangible asset and is therefore classified separately as
goodwill, which is discussed later in the chapter.
Some types of intangible assets are listed below.
• Patents, copyrights, databases, software, and website development costs
• Trademarks and trade names
• Franchise agreements’ initial fees and closing costs
• Purchased-only customer lists, brands, or publishing titles
In a Canadian context, intangible assets have the following characteristics:
• Patents are sole rights granted by the Canadian Patent Office to exclude others from
making, using, or selling an invention. They expire after twenty years. Patents limit
competition and therefore they provide incentive for companies or individuals to continue
11.2. Intangible Assets: Initial Recognition and Measurement 399
developing innovative new products or services. For example, pharmaceutical compa-

nies spend large sums on research and development, so patents are essential to earning
a profit.
• Copyrights grant exclusive legal right to the author to copy, publish, perform, film, or
record literary, artistic, or musical material. A copyright protects authors during their
lifetimes and for fifty years after that. A recent example of copyright infringement involves
Michael Robertson, CEO of the now-bankrupt MP3.com. The former chief executive of
the online music storage firm MP3Tunes was found liable in March 2014 for infringing
copyrights for sound recordings, compositions, and cover art associated with artists
including the Beatles, Coldplay, and David Bowie (Raymond, 2014).
• Trademarks are a symbol, logo, brand, emblem, word, or words legally registered or
established by use as representing a company or product. Coca Cola is an example.
Trademarks are renewable after fifteen years, so they can have an indefinite life.
• Industrial design (ID) creates and develops concepts and specifications that improve the
function, value, and appearance of products and systems. Registration of the design
results in exclusive rights being granted for ten years.
11.2 Intangible Assets: Initial Recognition and Measurement
Recognition as an intangible asset is based on both criteria being met:
1. the probability that benefits will flow to the business and
2. the asset cost can be reliably measured.
If these are not met, then the item is expensed when it is incurred.
If the three conditions of an intangible asset and the two recognition criteria above are met,
then the intangible asset is:
• initially measured at cost
• subsequently measured at cost (or measured using the revaluation model for IFRS)
• amortized on a systematic basis over its useful life (unless the asset has an indefinite
useful life, in which case it is not amortized). For IFRS, the intangible asset is tested
annually for impairment.
Intangible assets can be acquired:
• as a separate purchase
• as part of a business combination (either through the purchase of the business’s assets
or acquiring the controlling shares of the business)
• by an exchange of assets
• by a government grant
• by self-creation (internally developed)
11.2.1 Purchased Intangible Assets
Costs are capitalized to intangible assets the same way as is done for property, plant, and
equipment. As a basic review, capital costs include the acquisition cost, legal fees, and any di-
rect costs required to get the intangible asset ready for use. If intangible assets are purchased
with other assets, the cost is then allocated to each asset based on relative fair values (basket
purchase). Other costs, such as training to use the asset, marketing, administration or general
overhead, interest charges due to late payment for the asset purchase, and any costs incurred
after the asset is put into its intended use, are expensed as incurred.
Like property, plant, and equipment, intangible assets that are purchased in exchange for other
monetary and/or non-monetary assets are measured at either the fair value of the assets given
up or the fair value of the intangible asset received, whichever is the most reliable measure, if
there is commercial substance. When an exchange lacks commercial substance, the assets
received are measured at the lessor of the carrying amount or the fair value of the assets given
up.
If a company receives an intangible asset at no cost or for a nominal cost in the form of a
government grant such as a grant of timber rights, then the fair value of the intangible asset
acquired is typically the amount recorded.
11.2.2 Internally Developed Intangible Assets
All company activities to create new products or substantially improve existing products are to
be separated into a research phase and a development phase for the various costs incurred.
Below is a summary of the two phases and their accounting treatment (IFRS, 2014; IAS 38
Intangible Assets):
Research Phase: Development Phase:

All original and planned in- This is where the application of research findings before
vestigation activities includ- commercial production begins. It includes designing,
ing evaluating and selecting testing and constructing prototypes, models, pilot plants
products or processes from chosen from the alternatives identified in the research
several possible alternatives. phase, as well as costs for any new tools, templates, or
If there is any uncertainty castings.
about which phase is appro-
priate for an activity, then the
research phase is used.
1) Technical feasibility of
completing the intangible as-
set must be proven.
2) Management intention
exists to complete it for use
or for sale.
3) The entity must be able to
IAS 38: the six criteria must use or sell it.
ALL be met to be 4) Adequate resources to
capitalized, otherwise costs complete the development
are expensed as incurred. and to use or sell the intan-
gible asset are available.
5) Probability of future eco-
All costs are expensed as nomic benefits is clearly es-
incurred because the tablished and are reason-
activities do not relate to an ably certain, such as the
identifiable product or existence of a market or the
process. usefulness of the intangible
asset to the entity.
6) Costs can be reliably
measured
Costs that are initially ex-
pensed because they do not
meet the six criteria above
cannot be capitalized later.
Typical ineligible costs for Business start-up costs,

capitalization: training, advertising and
promotion, relocation,
reorganization costs or
any costs after the asset
is ready for use/sale.
Internally generated
branding or customer
lists are also excluded from
capitalization because they
are indistinguishable from
other business costs.
Once the six criteria are met, Any external or internal costs
direct costs that are eligible: directly attributable to the
specific asset such as direct
materials and direct labour
(i.e., salaries and benefits),
as well as other direct costs
such as engineering costs,
and any directly attributable
overhead costs.
Once the intangible asset is
ready for its intended use,
then any subsequent costs
are expensed and no longer
capitalized.
For ASPE, CPA Handbook, Sec. 3064, Goodwill and Intangible Assets (CPA Canada, 2016),
allows a choice between expensing the costs for internally developed intangibles or recogniz-
ing the intangible asset when certain criteria (similar to the criteria above) are met.
11.2.3 Intangible Assets: Subsequent Measurement
After the initial recognition and measurement, subsequent measurement is as follows:
• ASPE–Cost model only
• IFRS–Cost model. If the intangible asset has its fair values determined in an active
market, then the Revaluation model can be used. The Revaluation model is not widely
used in actual practice since an active market for intangible assets usually does not exist.
The accounting treatment under both models is applied the same way as is applied to property,
plant, and equipment. Since intangible assets rarely have an active market to provide readily
available fair values, discussions in this chapter will focus on the cost model.
Cost Model
• Asset is initially recorded upon acquisition at its cost.
• Subsequently, its carrying value will be at cost less accumulated amortization and accu-
mulated impairment losses since acquisition, if any.
• On disposal, its carrying value is removed from the accounts and any gain or loss (sales
proceeds minus the carrying value) is reported in net income.
An intangible asset with a limited useful life will be amortized over its estimated useful life, like
plant and equipment, as follows:
• Amortization can be calculated using the units of production or straight-line methods,

but usually assuming a residual value of zero (unless it can be sold to a third party).
The method to use is determined using similar criteria as plant and equipment. Nearly
all intangible assets are amortized using the straight-line method with no residual value
unless there is compelling evidence to prove otherwise.
• Estimating useful life considers criteria such as expected use of the assets, any limits
imposed by law, statute, or contract, and the impact on value from obsolescence and
technology advances. If a patent has a legal life of twenty years but expects a competing
product to emerge in fifteen years, then the useful life would be the lesser of the two, or
fifteen years.
• Amortization begins and ends according to when the asset is ready for use and when it
is to be disposed of or sold.
• Amortization policy is reviewed in terms of the asset’s useful life, amortization method,
and residual value, if any.
• Changes in useful life, residual value (if any), and amortization method are changes in
accounting estimates and accounted for prospectively.
• Intangible assets are reviewed for impairment at the end of each reporting period (IFRS),
or whenever circumstances indicate that the carrying value of the asset may not be
recoverable (ASPE).
If the intangible asset has an indefinite life, no amortization is recorded, but it will be subject
to review at the end of each reporting period. Should this status change to a definite life, it is
treated as a change in estimate and accounted for prospectively. Indefinite life assets are also
subject to impairment reviews and adjustments.
11.2.4 Intangible Assets: Impairment and Derecognition
The process of impairment and derecognition of intangible assets is like that of property, plant,
and equipment. Below is a summary of two models used for definite-life and indefinite-life
intangible assets.
ASPE Cost Recovery Impairment Model IFRS: Rational Entity Impairment Model
Assumes that the asset will continue to be Assumes that the asset will either continue
used. The asset is impaired only if the carrying to be used or disposed of, depending upon
value of the asset is more than the sum of the which results in a higher return. The asset is
net future undiscounted cash flows from both impaired only if the carrying value of the asset
the use and eventual disposal of the asset. is more than the asset’s recoverable amount
(a discounted cash flow concept), being the
higher of its value in use and its fair value less
costs to sell.
Definite-Life Intangible Assets
Impairment Only when events Impairment An assessment is
recognition and circumstances recognition made at the end of
indicate that the each reporting
carrying value may period as to whether
not be recoverable, there is any
as determined by a indication that the
recoverability test. asset is impaired.
Recoverability test If the carrying value Recoverability test None
is greater than the
undiscounted future
cash flows, then the
asset is impaired,
and the impairment
loss is calculated.
Impairment loss The asset carrying Impairment loss 1) Calculate the

value less fair value. recoverable amount
as the higher of the
value in use and the
fair value less costs
to sell.
2) If the asset
carrying value is
more than the
recoverable amount,
then the asset is
impaired by the
difference between
these two amounts.
Impairment reversal Not permitted Impairment reversal If the recoverable
amount has
increased, then a
reversal is allowed,
but it cannot exceed
the asset’s carrying
value excluding any
impairments.
Indefinite-Life Intangible Assets
Impairment Only when events Impairment Tested for
recognition and circumstances recognition impairment annually.
indicate impairment
is possible as
determined by a fair
value test.
Fair value test If the carrying value Fair value test None
is greater than the
fair value, then the
asset is impaired,
and the loss is
calculated.
Impairment loss Equal to the Impairment loss Same as for
difference resulting definite-life
from the fair value intangible assets
test. above.
Impairment reversal Not permitted. Impairment reversal Same as for
definite-life
intangible assets
above.
The entry for impairment for both ASPE and IFRS is:
General Journal
Loss on impairment . . . . . . . . . . . . . . . . . . . . . . . . . . . $$
Accumulated impairment losses, intangible $$
asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accumulated impairment losses is a contra
asset account.
Amortization calculation after impairment for both ASPE and IFRS is based on the adjusted
carrying value after impairment, the revised residual value (if any), and the asset’s estimated
remaining useful life.
carrying value after impairment − revised residual value (if any)

Revised amortization =
Estimated remaining useful life
When an intangible asset is disposed of, the difference between the net proceeds and the
asset’s carrying value is the gain or loss reported in net income. The asset and its accumulated
amortization are removed from the accounts.
11.3 Goodwill
11.3.1 Initial Recognition and Measurement
Goodwill arises when one company purchases another business and pays more than the
fair value of its net identifiable assets (total identifiable assets – identifiable liabilities). This
excess amount of consideration paid by the purchaser is classified as goodwill. As discussed
at the beginning of this chapter, since goodwill is not a separately identifiable asset and
has no contractual or other legally enforceable rights, it does not meet the definition of an
intangible asset. It is therefore classified separately as goodwill on the SFP/BS. Also, a third-
party purchase is the only circumstance where goodwill can be recognized. This is due to
the complexities of recognizing and measuring internally generated goodwill, which lacks any
arm’s-length third-party associations.
11.3. Goodwill 407
All the identifiable assets and identifiable liabilities received are initially recorded by the pur-
chaser at their fair values at the date of purchase. The difference between the sum of the fair
values and the purchase price (or the fair value of any consideration given up) is classified and
recorded as goodwill. Consideration can be cash or other assets, notes payable, shares, or
other equity instruments.
For example, on January 1, Otis Equipment Ltd. purchases the net identifiable assets of Wa-
verly Corp. for $40M cash and a short-term promissory note for $12M. Waverly’s unclassified
year-end balance sheet as at December 31 is shown below.
Waverly Corp.
Balance Sheet
December 31, 2019
(in $000s)
Assets Liabilities and shareholders’ equity

Cash $ 50,000 Accounts payable $ 85,000
Accounts receivable (net) 15,000 Mortgage payable due Dec 31, 2029 100,000
Inventory 35,000 Share capital 40,000
Building (net) 100,000 Retained earnings 5,000
Equipment (net) 25,000
Patent (net) 5,000
Total assets $230,000 Total liabilities and equity $230,000
To determine the amount of consideration (cash and short-term promissory note) to offer
Waverly, Otis completed a detailed fair value analysis of the net identifiable assets, as shown
below.
Fair Values
December 31, 2019
(in $000s)
Cash $ 50,000
Inventory 33,000
Building 125,000
Equipment 15,000
Patent 0
Accounts payable (85,000)
Mortgage payable, due Dec 31, 2029 (100,000)
Total fair value of net identifiable assets $ 50,000
Differences between fair values and the carrying values of the net identifiable assets are
common. For example, the accounts receivable may be adjusted because the bad debt
estimate was not sufficient. Inventory may be adjusted due to obsolescence or due to a recent
decline in prices from the supplier. Long-term assets values for property, plant, and equipment
are usually determined either by independent appraisals or from published pricing guides such
as those used for vehicles. Vehicles will lose value as they age, but land and buildings can
appreciate over time. The patent may have been assessed a zero value because it was almost
fully amortized and was due to expire the next year. Fair values for current liabilities such as
accounts payable are usually the same as their book values. Long-term liabilities may require
adjustments if interest rates have significantly changed.
The total consideration given up by Otis is $52M combined cash and short-term promissory
note compared to the fair value of the net identifiable assets of $50M. The $2M difference
will be classified as goodwill. As previously stated, goodwill is not an identifiable asset on
its own but simply that portion of the purchase price not specifically accounted for by the net
identifiable assets. In other words, goodwill represents the future economic benefits arising
from other assets acquired in the business acquisition that cannot be identified separately.
Otis would make a journal entry as shown below.
General Journal
Jan 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33,000
Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125,000
Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000
Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Short-term promissory note payable. . . . . . . . 12,000
Mortgage payable . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000
Any transaction costs incurred by Otis associated with the purchase would be expensed as
incurred.
There are many reasons why Otis was willing to pay an additional $2M to purchase Waverly.
Waverly may possess a top credit rating with its creditors, an excellent reputation for quality
products and service, a highly competent management team, or highly skilled employees.
These factors will positively affect the total future earning power and hence the value of the
business entity.
If Waverly accepted an offer from Otis of $49M and the fair values of the net identifiable
assets of $50M were re-examined and considered accurate, then the $1M difference would
be recorded by Otis as a gain (credit) from the acquisition of assets in net income. This is
referred to as a bargain purchase.
11.3. Goodwill 409
11.3.2 Subsequent Measurement of Goodwill
Once purchased, goodwill is deemed to have an indefinite life and not amortized, but it is
evaluated for impairment. Under IFRS, this is done annually and whenever there is an indica-
tion that impairment exists. For ASPE this is done whenever circumstances indicate that an
impairment exists.
Since goodwill is not a separately identifiable asset, it is allocated to reporting (ASPE) or

cash generating units (CGUs; IFRS) expected to benefit from the business acquisition on the
acquisition date.
For ASPE, after testing and adjusting the individual assets of the CGU as required, impairment
is then applied to the whole reporting unit the same as for intangible assets with an indefinite
life. If the carrying value of the reporting unit is greater than its fair value, this difference is the
impairment amount.
For IFRS, if the carrying value of the CGU is greater than the recoverable amount (which is
the higher of the CGU’s value in use or fair value less costs to sell) then this difference is the
impairment amount. Impairment is allocated first to goodwill (accumulated impairment losses,
goodwill account), with any further excess allocated to the remaining assets’ carrying values
in the CGU on a proportional basis.
Goodwill impairment reversals are not permitted for ASPE or IFRS.
For example, assume that Calter Ltd. purchased Turnton Inc. and identified it as a reporting unit
(CGU). The goodwill amount that was recorded at acquisition was $40,000 and the carrying
amount of the whole unit, including goodwill was $360,000. One year later, due to an economic
downturn in that industry sector, management is assessing whether the unit has incurred
an impairment of its net identifiable assets. The fair value of the unit was evaluated to be
$330,000. The direct costs to sell would be $9,300 and the unit’s value in use is $340,000.
Under ASPE:
After testing and adjusting the individual assets within the unit, the whole unit was evaluated
at a fair value of $330,000 as stated in the scenario above.
Carrying amount of whole unit, including goodwill $360,000

Fair value of the unit 330,000
Goodwill impairment loss $ 30,000
The entry to record the loss is shown below.
General Journal
Accumulated impairment losses, goodwill . . 30,000
asset account.
The net carrying value for goodwill will be $10,000 ($40,000 − 30,000). Since individual asset
testing and adjustments within the unit was done prior to the evaluation of the whole unit, the
impairment amount would not exceed goodwill.
Under IFRS:
Carrying amount of CGU as a unit, including goodwill $360,000
Recoverable amount of unit 340,000
(Higher of value in use of $340,000
and fair value less costs to sell
330,000 − 9,300 = $320,700)
Goodwill impairment loss $ 20,000
Entry to record the loss is shown below.
General Journal
Accumulated impairment losses, goodwill . . 20,000
asset account.
The net carrying value for goodwill after the impairment is $20,000 ($40,000 − 20,000). Had
the impairment amount exceeded the $40,000 goodwill carrying value, the amount of the
difference would be allocated to the remaining net identifiable assets on a prorated basis,
since there had been no impairment testing of individual assets as was done for ASPE above.
11.4 Disclosures of Intangible Assets and Goodwill
For reporting purposes, intangible assets are grouped together with similar other intangible
assets. Some examples of these classes are patents, copyrights, computer software, or
11.5. Analysis 411
industrial designs. Most of the disclosures will be in the notes to the financial statements.
Disclosures for ASPE are simpler than IFRS. For each class, some of the most important
disclosures are listed below.
• Identify if the intangible assets have a definite or indefinite life, or were purchased or
internally developed.
• Identify useful life, amortization policy and rate, the accumulated amortization for definite-
life assets, and carrying amount for both definite- and indefinite-life assets.
• Disclose amortization amounts included in the line items of the statement of income or
comprehensive income.
• Disclose the amount of research and development costs expensed through net income.
• Reconcile the beginning and ending balances of each class of intangibles, including ac-
quisitions, increases in internally generated intangibles, amortizations, and impairments.
• Goodwill is reported as a separate line item with its carrying value and impairments
amounts disclosed.
• Disclose capitalization policies.
11.5 Analysis
Analysis of financial statements will be affected by how intangible assets are accounted for.
For example, companies that follow ASPE can either capitalize or expense their internally
developed intangibles, depending upon company policy. More flexibility means less compa-
rability when evaluating performance with other companies within the industry sector. Policy
changes regarding intangible assets are treated prospectively within a company. This can
also impact comparability within the company when analyzing performance trends over time.
For IFRS companies, once the six conditions and criteria are met for internally developed
intangibles, they are capitalized as assets. This results in greater comparability when analyzing
performance.
Another issue involves company valuations. The SFP/BS does not always capture the com-
pany’s true value. This in turn will affect performance evaluation within the company and within
its industry sector. Recall the discussion at the beginning of this chapter regarding BioWare,
whereby the company’s total value can increase due to the development of creative software
development teams with extraordinary talents or perhaps a superior management team. Since
these cannot be measured reliably, they are not reported in any of the financial statements.
There is no doubt that these attributes are relevant and will positively affect the company’s total
value, but without quantification within the financial statements, they will likely have little impact
on decision-making such as what a creditor would be willing to loan the company to expand
their markets, or what additional monies a purchaser might be willing to pay to purchase the
company.
Item ASPE IFRS

(Sec. 3064) (IAS 38)
Intangible assets: Those development costs Costs are separated into
internally developed meeting ALL the six criteria research and development.
in the development phase All research costs are
may be capitalized or expensed. Those
expensed. development costs meeting
ALL the six criteria in the
development phase are to
be capitalized:
1) technical feasibility
2) management intention to
complete
3) ability to use or sell
4) adequate resources
5) future economic benefits
and existence of a market or
usefulness of the intangible
asset to the entity
6) costs are reliably
measurable.
Intangible assets: Cost model: measured at Policy choice to use either
subsequent measurement cost less accumulated cost model (usually) or
amortization (definite-life revaluation model (only if an
assets only) and impairment active market exists).
losses since acquisition.
Intangible assets: For definite-life intangible For both definite-life and
impairment assets: if the carrying value indefinite-life intangible
is greater than the assets:
undiscounted future cash
flows, then asset is 1) Calculate the recoverable
impaired. The impairment amount as the higher of the
loss is calculated as the value in use and the fair
difference between the value less costs to sell.
carrying value and fair value.
Chapter Summary 413
For indefinite-life intangible 2) If the asset carrying value

assets: if carrying value is is more than the recoverable
greater than fair value then amount, then the asset is
asset is impaired for that impaired by the difference
amount. between these two amounts.
Impairment is not reversible. Impairment is reversible but

the amount is limited to the
asset’s carrying value had
no impairment occurred.
Disclosure of intangible Basic disclosures are Detailed disclosures are
assets and goodwill required such as reporting required for intangibles and
intangible assets by class goodwill. For each class,
with details about identify amortization policy,
amortization policy and impairment losses,
impairment losses. Goodwill reconciliation of opening to
impairment details also closing balances details,
disclosed. and capitalization policies.
Disclose research and
development costs that were
expensed.
(Sources: CPA Canada, 2016; IFRS, 2014)
Chapter Summary
LO 1: Describe intangible assets and goodwill and their role in accounting and
business.
Intangible assets and goodwill can have significant balances reported in a company’s SFP/BS.
To be classified as an intangible asset, it must be identifiable, non-monetary, without physical
substance, be controllable by business, and with expected future benefits. Some examples of
intangible assets are patents, copyrights, trademarks, and purchased customer lists. Goodwill,
on the other hand, can only occur because of a purchase of another company’s net identifiable
assets. Any excess proceeds paid over the total fair value of these net identifiable assets will
be classified and reported separately as goodwill.
LO 2: Describe intangible assets and explain how they are recognized and
measured.
To be recognized as an intangible asset for accounting purposes, there must be a probability

that future benefits will accrue to the business and that they can be reliably measured. If not,
the item is expensed as incurred. Intangible assets can be acquired as a separate purchase
or as part of a business combination, in exchange for other assets, as part of a government
grant or as internally developed. Intangible assets are initially measured at cost. Initial costs
that can be capitalized to the asset are any direct costs required to get the asset ready for use.
Any costs incurred after the asset is put into use are expensed.
Intangible assets that are internally developed are subject to more stringent criteria and are
separated into research and development phases. Research phase costs are expensed as
incurred because there is no identifiable product or process yet. Development phase costs
meeting all six criteria can be capitalized. Initial costs that can be capitalized are any direct
costs required to get the asset ready for use. All other costs are expensed and cannot be
capitalized at later.
Once the asset is in use, it is usually subsequently measured at amortized cost or cost (ASPE
or IFRS) or, less often, using the fair-value based revaluation model (IFRS only). Definite-
life intangible assets are amortized on a systematic basis the same as property, plant, and
equipment. Indefinite-life assets are not amortized but the indefinite-life status is subject to
review.
Evaluation for impairment is undertaken at certain points over time for all intangible assets the
same as is done for property, plant, and equipment. For definite life intangibles, ASPE evalu-
ates for indicators of impairment only when circumstances indicate impairment is a possibility
as determined by a recoverability test that compares the carrying value with the undiscounted
future cash flows. If impaired, the asset’s carrying value is reduced to equal the fair value at
that date and the loss on impairment is reported in net income. Impairment reversals are not
permitted.
IFRS evaluates for indicators of impairment at the end of each year. There is no impairment
test. If impaired, the asset carrying value is reduced to equal the recoverable amount (the
higher of the value in use and the fair value less costs to sell). Impairment reversals are
limited and cannot exceed the asset’s carrying value without any impairment adjustments.
For indefinite intangible assets, ASPE evaluates for indicators of impairment only when circum-
stances indicate impairment is a possibility as determined by a fair value test that compares
the carrying value with the fair value. If impaired, the asset’s carrying value is reduced to equal
the fair value at that date and the loss on impairment is reported in net income. As was the
case for definite-life intangibles, impairment reversal is not permitted.
For IFRS, indefinite-life intangibles are treated the same as definite-life intangibles regarding
Chapter Summary 415
impairment evaluation and measurement.
Amortization is based on the adjusted carrying value after impairment, the revised residual
value, and the estimated remaining useful life.
On disposal, the asset is removed from the accounts and any gain or loss reported in net
income.
LO 3: Describe goodwill and explain how it is recognized and measured.
Goodwill can only arise from a third-party purchase of another company’s net identifiable
assets. Goodwill is calculated as the difference between the consideration price (e.g., cash,
other assets, notes payable, shares) and the fair value of the net identifiable assets; it is
reported separately as a long-term asset on the SFP/BS. The purchaser records all the net
identifiable assets at their fair values and any resulting goodwill on the SFP/BS as at the
purchase date. If the purchase price were to be less than the fair value of the net identifiable
assets, the difference would be credited as a gain from the acquisition of assets in net income.
Goodwill is considered to have an indefinite life, so it is not amortized. Goodwill is assigned

as part of a reporting or cash-generating unit (CGU), and the whole unit is assessed for
impairment using the same measurement criteria as for intangible assets with an indefinite
life. The only difference is that goodwill impairment reversals are not allowed for either ASPE
or IFRS.
LO 4: Identify the disclosure requirements for intangible assets and goodwill.
For reporting purposes, intangible assets are usually grouped with other intangibles with
similar characteristics. For ASPE, the disclosures are simpler than for IFRS companies.
Most of the disclosures are made in the notes to the financial statements. Disclosures in-
clude separate reporting into various classes for definite-life and indefinite-life intangibles,
with goodwill being reported separately. Amortization and capitalization policies, amortization
amounts, impairment assessments and amounts, and reconciliations of beginning to ending
balances for each class of intangible asset disclosures are also required. Amounts expensed
for amortization expense and research and development costs are also disclosed.
LO 5: Describe how intangible assets and goodwill affect the analysis of company
performance.
Comparability is affected by the differences between how the accounting standards are applied
for purchased assets versus internally developed intangibles and goodwill for both ASPE and
IFRS companies. Any changes in accounting policies are treated prospectively, making com-
parability within a company or between companies over time more difficult. Valuation issues
are significant regarding unreported intangible assets that have been expensed because the
conditions and criteria identified in the ASPE and IFRS standards to qualify as an asset were
not met. Since these are not reported on the SFP/BS, valuation of these companies becomes
increasingly more difficult.
LO 6: Explain the similarities and differences between ASPE and IFRS for
recognition, measurement, and reporting for intangible assets and goodwill.
The differences between ASPE and IFRS arise regarding the following.
1. There is a choice to capitalize or expense internally developed intangible assets for

ASPE companies. For IFRS, there is no choice: if they meet the conditions and criteria,
then these expenses are to be capitalized.
2. Evaluation and measurement of impairment losses.
3. The extent of the required disclosures in the financial statements.
References
IFRS. (2015). International Financial Reporting Standards 2014. London, UK: IFRS Founda-
tion Publications Department.
Musk, E. (2014, June 12). All our patent are belong to you. Tesla [Blog]. Retrieved from http
://www.teslamotors.com/blog/all-our-patent-are-belong-you
Raymond, N. (2014, March 19). Ex-MP3tunes chief held liable in music copyright case.
Reuters. Retrieved from http://www.reuters.com/article/2014/03/19/us-mp3tunes-i
nfringement-idUSBREA2I29J20140319
Exercises 417
Exercises
EXERCISE 11–1
Indicate whether the items below are to be capitalized as an intangible asset or expensed.
Which account(s) would each item be recorded to?
a. Salaries of research staff
b. Costs to test prototypes
c. Borrowing costs for development of a qualifying intangible asset
d. Executive salaries for time spent on development of an intangible asset
e. Costs to launch a new product
f. Purchase cost of a patent from a third party
g. Product research costs
h. Costs internally incurred to create goodwill
i. Legal costs to successfully defend a patent
j. Purchase price of new software
k. Training costs for new software
l. Direct costs of special programming needed when purchasing new software
m. Costs incurred in forming a corporation for purposes of commercializing a new product
n. Operating losses incurred in the start-up of a business to manufacture a patented pro-

duce
o. The purchase cost of a franchise
p. The cost of developing a patent
q. The cost of purchasing a patent from an inventor
r. Legal costs incurred in securing a patent
s. The cost of purchasing a copyright
t. Product development costs
u. Consulting fees paid to a third party for advice on a research project

v. The cost of an annual update on payroll software
w. Interest or borrowing costs specifically identifiable with an internally developed intangible

asset
x. Materials consumed in the development of a product at the manufacturing stage for an

IFRS company
y. Materials consumed in research projects
z. General borrowing costs on the company’s line of credit
aa. Indirect costs allocated to research and development projects
EXERCISE 11–2
Harman Beauty Products Ltd. produces organic aromatherapy hand soaps and bath oils to re-
tail health stores across North America. The company purchased the trademark and patented
recipes for this unique line of soaps and oils, called Aromatica Organica, five years ago for
$150,000. Each type of soap or oil is made from a secret recipe only known to the head
“chef” at Harman who distributes the ingredients for each type of soap or oil to small groups of
“cooks” who then combine the unknown ingredients into a small batch of a particular type of
soap or oil. These are then packaged and shipped to fill each order placed by the retail stores
through the colourful and user-friendly website developed by Harman.
Required:
a. Identify any intangible assets that may appear on the company’s SFP/BS.
b. Discuss the importance of the intangible assets to the company’s business.
c. Why it is important to record intangible assets on a company’s SFP/BS?
EXERCISE 11–3
On January 1, 2020, a patent with a book value of $288,000 and a remaining useful life of
fourteen years was reported on the December 31, 2019 post-closing trial balance. In 2020, a
further $140,000 of research costs was incurred during the research phase. A lawsuit was also
brought against a competitor company regarding the use of a patented process for which legal
costs of $42,000 were spent. On September 1, 2020, the lawsuit was concluded successfully,
and the courts upheld the patent as valid, so the competitor would not be able to continue
using the patented process. The company year-end is December 31 and follows IFRS.
Exercises 419
Required: What amount should be reported on the SFP at December 31, 2020, assuming
straight-line amortization?
EXERCISE 11–4
Indicate how the items below are to be reported as assets in the SFP/BS as at December 31,
2020:
a. January 1, copyright obtained for a book developed internally for $25,000, which is esti-
mated to have a useful life of five years. Assume the straight-line method for amortization
and that all costs were incurred on January 1.
b. January 1, copyright obtained for a book purchased from Athabasca University for $35,000
cash with an indefinite useful life.
c. On January 1, 2020, an Internet domain name with an indefinite life was purchased in
exchange for a three-year, note. The market rate at that time was 8%. The note is
repayable in three annual principal and interest payments of $14,500 each December
31.
EXERCISE 11–5
Trembeld Ltd. was developing a new product, and the following timeline occurred during 2020:
January 1 to March 31, 2020 incurred the following costs:

Materials $180,000
Direct labour 64,000
April 1, criteria to capitalize costs were met
May 1 to July 31, 2020, incurred the following costs:

Materials 270,000
Direct labour 86,000
Directly related legal fees 25,400
Borrowing costs 8,600
Required:
a. How would Trembeld account for the costs above if the company followed ASPE?
b. How would Trembeld account for the costs above if the company followed IFRS?
EXERCISE 11–6
Crellerin Ltd. has a trademark with a carrying value of $100,500 that has an expected life of
fifteen years. At December 31, 2020 year-end, an evaluation of the trademark was completed.
The following estimates follow:
Fair value $ 55,000

Fair value less costs to sell $ 50,000
Value in use $115,000
Undiscounted cash flows $152,000
Required:
a. Determine if the trademark is impaired as at December 31, 2020, if Crellerin follows

ASPE and indicators of an impairment exist.
b. Determine if the trademark is impaired as at December 31, 2020, if Crellerin follows

IFRS and trademark has been assessed for positive conditions of impairment.
c. How would the answers to part (a) and (b) change if the trademark had an unlimited
expected life?
EXERCISE 11–7
Fredickson Ltd. purchased a trade name, a patented process and a customer list for $1.2
million cash. The fair values of these are:
Trade name $380,000

Patented process $400,000
Customer list $450,000
Required: Prepare the journal entry for the purchase.
EXERCISE 11–8
Below are three independent situations that occurred for Bartek Corporation during 2020.
Bartek’s year-end is December 31, 2020.
Exercises 421
i. On January 1, 2017, Bartek purchased a patent from Apex Co. for $800,000. The patent
expires on the same date in 2025 and Bartek has been amortizing the patent over the
eight years. During 2020, management reviewed the patent and determined that its
economic benefits will last seven years from the date it was acquired.
ii. On January 1, 2020, Bartek bought a perpetual franchise from Amoot Inc. for $500,000.
On this date, the carrying value of the franchise on Amoot’s accounts was $600,000.
Assume that Bartek can only provide evidence of clearly identifiable cash flows for twenty
years but estimates that the franchise could provide economic benefits for up to sixty
years.
iii. On January 1, 2017, Bartek incurred development costs of $250,000. These costs meet
the six criteria, and Bartek is amortizing these costs over five years.
Required:
a. For situation (i), how would the patent be reported on the SFP/BS as at December 31,
2020?
b. For situation (ii), what would be the amortization expense for December 31, 2020?
c. For situation (iii), how would these development costs be reported as at December 31,
2020?
EXERCISE 11–9
On September 1, 2020, Verstag Co. acquired the net identifiable assets of Ace Ltd. for a cash
payment of $863,000. At the time of the purchase, Ace’s SFP/BS showed assets of $900,000,
liabilities of $460,000, and shareholders’ equity of $440,000. The fair value of Ace’s assets is
estimated at $1,160,000 and liabilities have a fair value equal to their carrying value.
Required:
a. Calculate the amount of goodwill and record the entry for the purchase.
b. Three years later, determine if there is an impairment, and calculate the impairment
loss assuming that Verstag follows IFRS and that goodwill was allocated to one cash-
generating unit (CGU). The carrying value of the unit was $1,925,000, the fair value was
$1,700,000, the costs to sell were $100,000, and the value in use was $1,850,000.
c. How would the answer for part b) be different if Verstag follows ASPE? Fair value is
$1,860,000.
EXERCISE 11–10
Indicate how each of the following items would be classified:
a. Excess of purchase price over the fair value of net identifiable assets of another business
b. Research costs
c. Annual franchise fee paid
d. Organizations costs
e. Cash
f. Accounts receivable
g. Prepaid expenses
h. Notes receivable
i. Research and development acquired in a business combination
j. Leasehold improvements
k. Brand names
l. Music copyrights
m. Investments in affiliated companies
n. Film contract rights
o. Discount on notes payable
p. Property, plant, and equipment
q. Land
r. Development phase activities (meets the 6 criteria for development phase)
s. Purchased trademarks
t. Excess of cost over fair value of net assets of acquired subsidiary
u. Costs of researching a secret formula for a product that is expected to be marketed for
at least fifteen years
Exercises 423
EXERCISE 11–11
On January 1, 2019, Josey Corp. received approval for a patent from the Patent Office. Legal
costs incurred were $25,000. On June 30, 2020, Josey incurred further legal costs of $35,000
to defend its patent against a competitor trying to sell a knock-off product. The court action
was successful. The patent has a life of twenty years.
Required:
a. What are the variables to consider in determining the useful life of a patent?
b. Calculate the carrying value of the patent as at December 31, 2019, and December 31,
2020.
c. Calculate the carrying value of the patent as at December 31, 2020, if management
decides on January 1, 2020 that the patent’s life is only fifteen years from the approval
date.
d. What are the accounting treatment and the issues if the patent was assessed to have an
indefinite life?
EXERCISE 11–12
Below is select information for the following independent transactions for Hilde Co., an ASPE
company:
i. On January 1, 2020, a patent was purchased from another company for $900,000. The
useful life is estimated to be fifteen years. At the time of the sale, the patent had a
carrying value on the seller’s books of $915,000. A year later, Hilde re-assessed the
patent to have only ten years’ useful life at that time.
ii. During 2020, Hilde incurred $350,000 in costs to develop a new electronic product. Of
this amount, $180,000 was incurred before the product was deemed to be technologi-
cally and financially feasible. By December 31, 2020, the project was completed. The
company estimates that the useful life of the product to be ten years, and earnings are
estimated to be $3.6 million over its useful life. Hilde’s policy is to capitalize any costs
meeting the ASPE criteria.
iii. On January 1, 2020, a franchise was purchased for $1.8 million. In addition, Hilde must
also pay 2% of revenue from operations to the franchisor. For the year ended 2020, the
revenue from the franchise was $5.6 million. Hilde estimates that the useful life of the
franchise is forty years.
iv. During 2020, the following research costs were incurred; materials and equipment of
$25,000; salaries and benefits of $250,000; and indirect overhead costs of $15,000.
(Assume a single entry in 2020 for these costs.)
Required:
a. For each independent situation above, prepare all relevant journal entries including any
adjusting entries for 2020 (and 2021 for situation i) for Hilde Co. Hilde’s year-end is
December 31 and follows ASPE.
b. Prepare a partial income statement and balance sheet for 2020, including all required
disclosures. Income tax rate is 27%.
c. Explain how the accounting treatment for each of the situations above would differ if
Hilde was a public company that followed IFRS.
d. Explain how limited-life intangibles are tested for impairment for ASPE and IFRS com-
panies. How is the impairment calculated for each standard?
EXERCISE 11–13
On January 1, 2020, Nickleback Ltd. purchased a patent from Soriato Corp. for $50,000 plus
a $60,000, five-year note bearing interest at 8% payable annually. Upon maturity a single
lump sum amount of $60,000 will be payable. The market-rate for a note of a similar risk and
characteristics is 9%. Nickleback estimates that the patent will have a future life of twenty
years. Nickleback follows ASPE.
Required: Prepare the journal entry for the patent purchase. (Hint: refer to chapter on long-
term notes receivable.)
EXERCISE 11–14
On January 4, 2020, a research project undertaken by Nasja Ltd. was completed and a patent
was approved. The research phase of the project incurred costs of $150,000, and legal costs
incurred to obtain the patent approval were $20,000. The patent is assessed to have a useful
life to 2030, or for ten years. Early in 2021, Nasja successfully defended the patent against
a competitor, incurring a legal cost of $22,000. This set a precedent for Nasja who was able
to reassess the patent’s useful life to 2035. During 2022, Nasja was able to create a product
design that was feasible for commercialization, but no more certainty was known at that time.
Costs to get the product design to this stage were $250,000. Additional engineering and
consulting fees of $50,000 were incurred to advance the design to the manufacturing stage.
Nasja follows IFRS.
Exercises 425
Required:
a. Prepare all the relevant journal entries for the project for 2020 to 2022, inclusive.
b. What is the accounting treatment for the engineering and consulting fees of $50,000?
EXERCISE 11–15
On December 31, 2020, a franchise that is owned by Horten Holdings Ltd. has a remaining life
of thirty-two years and a carrying amount of $1,000,000. Management estimates the following
information about the franchise:
Fair value 1,000,000
Disposal costs 45,000
Discounted cash flows (value in use) 1,100,000
Undiscounted future cash flows 1,200,000
Required:
a. Determine if the franchise was impaired at the end of 2020 and prepare the journal entry,
if any, if Horten follows IFRS.
b. Assume now that the recoverable amount was $950,000. Prepare the journal entry for
the impairment, if any (IFRS).
c. How would your answer in part (a) change if the fair value at the end of 2020 was
$1.35M?
d. Assume the amounts used for part (a). How would your answers change for parts (a)
to (c), if the franchise was estimated to have an indefinite life and last into perpetuity
(IFRS)?
e. How would your answers change for parts (a) to (c), if the company followed ASPE and
an indication of impairment existed?
f. How would your answer change for part (d) if the franchise was estimated to have an
indefinite life and last into perpetuity (ASPE)?
EXERCISE 11–16
On January 1, 2020, Boxlight Inc. purchased the net assets from Candelabra Ltd. for $230,000
cash and a note for $50,000. On that date, Candelabra’s list of balance sheet accounts was:
Carrying value Fair value – if different

than carrying value
Cash $ 55,000
Inventory 200,000
Land 15,000 $35,000
Buildings (net) 125,000 95,000
Equipment (net) 15,000 5,000
Patent (net) 25,000 0
Customer list (net) 5,000 0
Accounts receivable is shown net of estimated bad debt of $10,000. Buildings, equipment,
patent, and customer list are shown net of depreciation/amortization of $75,000, 15,000,
5,000, and 1,000, respectively.
Required:
a. Prepare the journal entry to record the purchase.
b. What would Boxlight have considered when determining the purchase price for $280,000?
c. On December 15, 2020, Boxlight suspected a possible impairment of the reporting

entity so it assessed the net assets that had a carrying value of $200,000 on that date.
Management determined that the fair value of the net assets, including goodwill, was
$180,000. Determine if there was any impairment of the reporting entity and record the
journal entry, if any. Boxlight follows ASPE.
d. Assume now that Boxlight follows IFRS and assesses the cash-generating unit annually
for impairment. How would the answer in part (c) change, given the CGU’s values as
follows:
Carrying amount $180,000

Fair value 160,000
Disposal costs 10,000
Value in use 170,000
e. How would your answer in (c) and (d) change if, one year later, there was an increase in
the fair value and recoverable amount to $190,000?
Solutions To Exercises
Chapter 2 Solutions
EXERCISE 2–1
Information asymmetry simply means that one party to a business transaction has more
information than the other party. This problem is demonstrated by the situation where business
managers know more about the business’s operations than outside parties (e.g., investors
and lenders). The information asymmetry problem can take two forms—adverse selection and
moral hazard. With adverse selection, a manager may choose to act on inside knowledge of
the business in a way that harms outside parties. Insider trading by managers using non-
public knowledge may distort market prices of securities and create distrust in investors.
Accounting attempts to deal with the problem by providing as much timely information to
the market as possible. Moral hazard occurs when a manager shirks or otherwise performs
in a substandard fashion, knowing that his or her performance as an agent is not directly
observable by the principal (owner). Accounting tries to deal with this problem by providing
information to business owners that can help assess management’s level of performance.
Although the field of accounting does attempt to solve these problems through the provision
of high quality information, information asymmetry can never be completely eliminated, so
the accounting profession will always seek ways to improve the usefulness of accounting
information.
EXERCISE 2–2
Canada allows privately-owned businesses to use Accounting Standards for Private Enter-
prise (ASPE) or International Financial Reporting Standards (IFRS), while requiring publicly
accountable enterprises to use IFRS. IFRS is partially or fully recognized in over 125 countries
as the appropriate accounting standard for companies that trade shares in public markets.
The main advantage of using a consistent standard around the world is that investors can
understand and compare investment opportunities in different countries without having to
make conversions or adjustments to reported results. This is an important feature as markets
have become more globalized and capital more mobile. By requiring IFRS for publicly-traded
companies, Canada has attempted to maintain the competitiveness of these companies in
international financial markets. By allowing private companies the option to report under
427
428 Solutions To Exercises
ASPE instead, standard setters have created an environment that could be more responsive
to local needs and unique, Canadian business circumstances. As well, many features of
ASPE are simpler to apply than IFRS, which may reduce accounting costs for small, non-
public businesses.
The major disadvantage of maintaining two sets of standards is cost. The burden of stan-
dard setters is increased, and these costs will ultimately be passed on to businesses that
are required to report. As well, having two sets of standards may create confusion among
investors and lenders, as public and private company financial statements may not be directly
comparable.
EXERCISE 2–3
The conceptual framework is a high-level structure of concepts established by accounting

standard setters to help facilitate the consistent and logical formulation of standards, and
provide a basis for the use of judgment in resolving accounting issues. This framework
is essential to standard setters as they develop new accounting standards in response to
changes in the economic environment. The framework gives the standard setters a basis and
set of defining principles from which to develop new standards. The framework is also useful
to practicing accountants, as it can provide guidance to them when interpreting unusual or new
business transactions. The framework gives practicing accountants the tools and support to
critically evaluate accounting treatments of specific transactions that may not appear to fit into
standard definitions or norms. Without a proper conceptual framework, accounting standards
may become inconsistent and ad-hoc, and their application may result in financial statements
that are not comparable, resulting in less confidence in capital markets.
EXERCISE 2–4
The two fundamental characteristics of good accounting information are relevance and faithful
representation. Relevance means that the piece of information has the ability to influence
one’s decisions. This characteristic exists if the information helps predict future events or
confirm predictions made in the past. Some relevant information may have both predictive and
confirmatory value, or it may only meet one of these needs. Faithful representation means that
the information being presented represents the true economic state or condition of the item
being reported on. Faithful representation is achieved if the information is complete, neutral,
and free from error. Complete information reports all the factors necessary for the reader to
fully understand the underlying nature of the economic event. This may mean that additional
narrative disclosures are required as well as the quantitative value. Neutral information is un-
biased and does not favour one particular outcome or prediction over another. Freedom from
error means that the reported information is correct, but it does not have to be 100% error free.
The concept of materiality allows for insignificant errors to still be present in the information, as
Chapter 2 Solutions 429
long as those errors have no influence on a reader’s decisions. Although both relevance and
faithful representation need to be present for information to be considered useful, accountants
face difficulties in achieving maximum levels of both characteristics simultaneously. As a result,
trade-offs are often required, which may lead to imperfect information. Accountants are also
often faced with a trade-off between costs and benefits. It may be too costly to guarantee 100%
accuracy, so a little faithful representation may need to be given up to maintain the relevance of
the information. This means that the accountant will need to apply good judgment in balancing
the trade-offs in a way that maximizes the usefulness of the information.
EXERCISE 2–5
The four enhancing qualitative characteristics are comparability, verifiability, timeliness, and
understandability. Comparability means information from two or more different businesses
or from the same business over different time periods can be compared. Verifiability means
two independent and knowledgeable observers could come to the same conclusion about
the information being presented. Timeliness means that information needs to be current and
not out of date. The older the information, the less useful it becomes for decision-making
purposes. Understandability means that a reader with a reasonable understanding of business
transactions should be able to understand the meaning of the accounting information being
disclosed. Timeliness is often in conflict with verifiability, as verification of information takes
time. Financial statements are almost always issued under deadlines; the optimal level of
verification may not be achieved. Likewise, understandability may be enhanced with more
careful drafting of the supplemental disclosures, but time constraints may interfere with this
function. Understandability and comparability may both be influenced by the company’s need
to keep certain information confidential in order to avoid giving away a competitive advantage.
All of these characteristics may be influenced by matters of cost. Businesses will make
rational decisions by weighing the costs of certain actions against the benefits received. Cost
considerations may result in accounting information not achieving the maximum levels of all of
the qualitative characteristics. Balancing the trade-offs of these characteristics with the cost
considerations is one of the largest challenges faced by practicing accountants.
EXERCISE 2–6
a. A reduction of both assets and equity
b. An exchange of equal value assets
c. An exchange of assets of unequal value resulting in income and expense and a resulting
increase in equity (assumes goods are sold for an amount greater than cost)
d. Recognition of an expense, resulting in a decrease in equity and a liability

e. An asset is received and an equal value liability is recognized
f. Recognition of an expense, resulting in a decrease in equity and a liability
g. An equal increase in an asset and equity
h. An equal increase in an asset and a liability
i. An exchange of assets of unequal value, resulting in income and an increase in equity
j. A recognition of an expense, resulting in a decrease in equity, and a contra-asset
EXERCISE 2–7
An item is recognized in the financial statements if it: (a) meets the definition of an element, (b)
can result in probable future economic benefits to or from the entity, and (c) can be measured
reliably. These criteria can be applied as follows.
a. The company has received an asset, but the company has not yet achieved substantial
performance of the contract. The contract will be performed as issues of the magazines
are delivered. Thus, the appropriate offsetting element to the asset is a liability, as a
future obligation is created. As each issue is delivered, the liability is reduced and income
can be recognized. The amount can be measured reliably, as the cash has already been
received and the price of each magazine issue has already been determined.
b. The appropriate element here is the liability that is being created by the lawsuit. Because
the lawsuit results from a past event that creates a present obligation to pay an amount in
the future, the definition of a liability is met. It also appears that the outflow of economic
benefits is probable, based on the lawyer’s evaluation. However, if there really is no way
to reliably measure the amount, then the liability should not be recognized. However, the
lawyers should make a reasonable effort based on prior case law, the facts of the case,
and so forth, to see if an amount can be reliably estimated. Even if the amount is not
recognized, the lawsuit should still be disclosed in the notes to the financial statements
as this information is likely relevant to those reading the financial statement.
c. An asset is normally created and income recognized when the invoice is issued. The
future economic benefit exists, is the result of a past event, and can be measured reliably,
based on the terms of the contract. In this case, however, there is some issue regarding
the probability of realizing the future economic benefits. A careful analysis of the situation
is required to determine if recognition of an asset is appropriate. Only the amount whose
collection can be deemed probable should be recognized. Even if the amount is not
recognized, the contract should still be disclosed in the supplemental information, as
this information is likely relevant to financial statement readers.
d. The question of whether this meets the definition of an asset needs to be addressed. Is
the goodwill being recorded a “resource controlled by the entity”? Goodwill, by definition,
is intangible, but it is not clear what exactly is generating the goodwill in this case. It is
difficult to say that this even meets the definition of an asset. If this definitional argument
is stretched, it would still be difficult to recognize the element, as it is unlikely to pass
the reliable measurement test. An asset based on the current share price is not reliably
measured, as share prices are volatile and transitory. No recognition of the asset and
corresponding equity amount is warranted in this case.
e. This does appear to meet the definition of a liability, as the past event (the drilling) results
in a present obligation (the requirement to clean up the site) in the future. This type of
liability should normally be recorded at the present value of the expected outflow of
resources in 10 years time, as this outflow is probable. The company may have some
difficulty measuring the amount, as they have no experience with this type of operation.
However, an estimate should be able to be made using engineering estimates, industry
data, and so forth. The other item that needs to be estimated is the appropriate discount
rate for the present value calculation. Again, the company can use its cost of capital
or other appropriate measure for this purpose. This liability and an expense should be
recognized, although estimation will be required. Additional details of the method of
estimation would also need to be disclosed.
EXERCISE 2–8
The four measurement bases are historical cost, current cost, realizable (settlement) value,
and present value. Historical cost represents the actual transaction cost of an element. This
is normally very reliably measured, but may not be particularly relevant for current decision
making purposes. Current cost represents the amount required to replace the current capacity
of the particular asset being considered, or the amount of undiscounted cash currently required
to settle the liability. This base is considered more relevant than historical cost, as it attempts
to use current market information to value the item. However, many items, particularly special
purpose assets, do not have active markets and are, thus, not reliably measured by this
approach. Realizable value represents the amount that an asset can currently be sold for in
an orderly fashion (i.e., not a “fire-sale” price) or the amount required to settle a liability in the
normal course of business. Again, this has the advantage of using current market conditions,
making it more relevant than historical cost. However, as with current cost, active disposal
markets for the asset may not exist. As well, realizable value is criticized as being irrelevant in
cases where the company has no intention of disposing of the asset for many years. Present
value is, perhaps, the most theoretically justified measurement base. In this case, all assets
and liabilities are measured at the present value of the related future cash flows. This measure
is highly relevant, as it represents the value in use to the organization. The problem with this
approach is that it is difficult to reliably estimate the timing and probability of the future cash
flows. As well, determinations need to be made regarding the appropriate discount rate, which
may not always have a clear answer.
EXERCISE 2–9
Capital maintenance refers to the amount of capital that investors would want to be maintained
within the business. This concept is important to investors, as the level of capital maintenance
required may influence an investor’s choice as to which company to invest in. The measure-
ment of an investor’s capital can be defined in terms of financial capital or physical capital.
Financial capital maintenance simply looks at the amount of money in a business, measured by
changes in the owners’ equity. This can be measured simply by looking at monetary amounts
reported in the financial statements. The problem with this approach is that it doesn’t take
into account purchasing power changes over time. The constant purchasing power model
attempts to get around this problem by adjusting capital requirements for inflation by using a
broadly based index, such as the Consumer Price Index. The problem with this approach is
that the index chosen may not accurately reflect the actual level of inflation experienced by
the company. Physical capital maintenance tries to get around this problem by measuring the
physical capacity of the business, rather than the financial capacity. The advantage of this
approach is that it measures the actual productivity of the business and is not affected by
inflation. The disadvantage of this method is that it is not easy or cost-effective to measure the
productive capacity of each asset within the business.
Because each capital maintenance model involves trade-offs, the conceptual framework does
not draw a conclusion on which approach is the best. Rather, it suggests that end needs of
the financial statement users be considered when determining to apply capital maintenance
concepts to specific accounting standards.
EXERCISE 2–10
Principles-based standards present a series of basic concepts that professional accountants

can use to make decisions about the appropriate accounting treatment of individual transac-
tions. Rules-based standards, on the other hand, are more prescriptive and detailed. These
standards attempt to create a rule for any situation the accountant may encounter. The
main advantage of principles-based systems is their flexibility. They allow the accountant
the latitude to apply judgment to deal with new situations or unusual circumstances. This
flexibility, however, can also cause problems for the accountant, as there could be pressure
to stretch the professional judgment in a way that creates misleading financial statements. As
well, the application of judgment in the preparation of financial statement could result in reports
that are not comparable, as other accountants may arrive at different conclusions for similar
transactions. This suggests that the verifiability characteristic may also be compromised.
The main advantage of rules-based approaches is the certainty and comparability offered by
detailed rules. Readers can have confidence that similar transactions are reported in similar
ways. As well, this may reduce the accountant’s professional liability, as long as the rules have
been applied correctly. The main disadvantage of the rules-based systems is their inflexibility.
Prescription of specific accounting treatments can result in financial engineering, wherein new
transactions are designed solely for the purpose of circumventing the rules. This can create
misleading financial reports, where the true nature of the transactions is not reflected correctly.
As well, overly detailed rules can create a problem of understandability, not only for the readers,
but even for the professional accountants themselves. As a practical matter, all systems of
accounting regulation contain both broad principles and detailed rules. The challenge for
accounting standard setters is to find the right balance of rules and principles.
EXERCISE 2–11
Managers may attempt to influence the outcome of financial reporting for a number of rea-
sons. Managers may have bonus or other compensation schemes that are directly tied to
reported results. Managers are rational in attempting to influence their own compensation, as
they understand that compensation earned now is more valuable than compensation that is
deferred to future periods. Even if the manager’s compensation is not directly tied to financial
results, the manager may still have an incentive to make the company’s results look as good as
possible, as this would enhance the manager’s reputation and future employment prospects.
Managers will also feel pressure from shareholders to maintain a certain level of financial
performance, as public securities markets can be very punitive to a company’s share price
when earnings targets are not reached. Shareholders do not like to see the price of the share
fall drastically. On the other hand, shareholders also want to have a realistic assessment of the
company’s earning potential. These conflicting goals may create a complicated dynamic for
the manager’s behaviour in crafting the financial statements. Managers are also influenced by
the conditions of certain contracts, such as loan agreements. Loan covenants may require the
maintenance of certain financial ratios, which clearly puts pressure on managers to influence
the financial reports in a certain fashion. Managers may also feel pressure to keep earnings
low where there are political consequences of being too profitable. This may occur when a
company has disproportionate power over the market, or where there is a public interest in the
operations of the business. The company does not want to demonstrate earnings that are too
high, as it risks attracting additional taxation, penalties, or other actions that may restrict future
business.
The pressures that managers feel to influence financial results will eventually find their way
to the accountant, as the accountant is ultimately responsible for creating the financial state-
ments. Whether the accountant is internal or external to the business, his or her work must
be performed ethically and professionally. The accountant must always act with integrity
and objectivity, and must avoid being influenced by the pressures that may be exerted by
managers or other parties. The accountant must demonstrate professional competence and
must keep client information confidential. The accountant should not engage in any work
that falls outside of the scope of that accountant’s professional capabilities. As well, the
accountant must not engage in any behaviour that discredits the profession. Although it is
easy to describe the accountant’s professional responsibilities, it is not always easy to put
these concepts into practice. The accountant needs to be aware of the pressures faced in
the reporting environment, and may need to seek outside advice when faced with ethical or
professional problems. Ultimately, the accountant is a key player in establishing the overall
credibility of financial reporting, and financial markets rely on this credibility to function in an
efficient manner.
EXERCISE 2–12
The vice-president finance’s comments hint at a threat to my objectivity as financial controller.

The potential reward of the vice-president finance position should not influence how I perform
my professional duties. The specific issues identified by the vice-president finance can be
addressed as follows.
a. This lawsuit appears to meet the definition of a liability, as it is a present obligation that
results from a past transaction and will require a future outflow of economic resources.
As well, it appears to have satisfied the recognition criteria, as the payment is probable
and the amount can be estimated. This amount should be accrued this year, although
prior years’ financial statements do not need to be adjusted. Further consultation with the
lawyers is required to determine the most reasonable amount to accrue within the range
provided. Also, IFRS and ASPE use different approaches to accounting for provisions
based on a range of values.
b. A change in accounting policy should be disclosed in the notes to the financial state-
ments. However, the change should also be accounted for in a retrospective fashion,
where prior years’ results are restated to show the effect of the change on those years.
This retrospective treatment may result in a change in the effect on the current year’s
income. This treatment is necessary to maintain comparability with prior years’ results.
c. Prepayments from customers appear to meet the definition of a liability, as they represent
a present obligation to deliver future resources to the customers (in this case, products
to be manufactured). The recognition criteria also appear to have been met, so these
amounts should be disclosed as liabilities. It is generally not appropriate to net assets
and liabilities together, as this distorts the underlying nature of the individual financial
statement elements.
d. It is unlikely that this even meets the definition of an asset, as it cannot be said that we
control the resource. Although we pay the research and development director’s salary
and likely have proprietary rights to his inventions, we cannot really say that the resource,
his knowledge, is controlled by the company. Even if we stretch the definition of an asset
here to include this knowledge, it still doesn’t meet the recognition criteria, as there
is no demonstration that the future flow of economic resources is either probable or
measurable.
e. The vice-president finance is indicating that year-end accounting adjustments need to

be considered for their effects on the debt-to-equity ratio. All of the accounting treat-
ments proposed by the vice-president finance would improve this ratio. However, all
of the proposed accounting treatments are likely unsupportable under the conceptual
framework. It appears that the vice-president finance’s objectivity may have been im-
paired by his requirement to prevent a debt covenant violation. It is likely that the vice-
president finance’s proposed accounting treatments will be challenged by the company’s
external auditors, which may create delays and other problems in issuing the financial
statements. This could also cause problems with the bank. In performing my duties
as the financial controller, I need to be aware of the threats to my objectivity. Although
there is no evidence of any ethical conflict yet, I will need to perform my duties with
integrity. If my actions do result in a conflict with the vice-president finance, I will need to
carefully consider my actions. I may need to seek outside advice from my professional
association and others, if necessary. Ultimately, I must ensure that I do not prepare
financial statements that are false or misleading in any way.
Chapter 3 Solutions
EXERCISE 3–1
a. Income from continuing operations = Income from operations + Gain on sale of FNVI
investments – Income tax on income from continuing operations = $125,000 + $1,500 −
$34,155* = $92,345
* (125,000 + 1,500) × 27% = 34,155
Net income = Income from continuing operations – Loss from operation of discontinued
division (net of tax) – Loss from disposal of discontinued division (net of tax) = $92,345 −
$2,500 − $3,500 = $86,345
Other comprehensive income = Unrealized holding gain – OCI (net of tax) = $12,000
Total comprehensive income = Net income + other comprehensive income = $86,345 +
$12,000 = $98,345
b. Under ASPE, other comprehensive income and comprehensive income do not apply.
EXERCISE 3–2
Quality of Earnings: In terms of earnings quality, there are issues. The company’s net income
includes a significant gain on sale of idle assets, which means that a sizeable portion of
earnings were not generated from ongoing core business activities. Wozzie also changed
their inventory policy from FIFO to weighted average, which is contrary to the method used
within their industry sector. This is cause for concern as it raises questions about whether
management is purposely trying to manipulate income. A change in accounting policy is only
allowed as a result of changes in a primary source of GAAP or may be applied voluntarily by
management to enhance the relevance and reliability of information contained in the financial
statements for IFRS. Unless Wozzie’s inventory pricing is better reflected by the weighted
average method, contrary to the other companies in their industry sector, the measurement of
inventory and cost of goods sold may be biased.
Investing in the Company: Investors and analysts will review the financial statements and see
that part of the company’s net income results from a significant gain generated from non-core
business activities (the sale of idle assets) and will also detect the lower cost of goods sold
resulting from the change in inventory pricing policy disclosed in the notes to the financial
statements. As a result, investors will assess the earnings reported as lower quality, and the
capital markets will discount the earnings reported to compensate for the biased information.
Had Wozzie not fully disclosed the accounting policy change for inventory, the market may
have taken a bit longer to discount that portion of the company’s net income due to lower
quality information.
EXERCISE 3–3
Eastern Cycles’ sale of the corporate-owned stores to a franchisee would not qualify for
discontinued operations treatment because the corporate-owned stores are not a separate
major line of business. Under IFRS, a component of an entity comprises operations, cash
flows, and financial elements that can be clearly distinguished from the rest of the enterprise,
which is not the case as stated in the question information.
Under ASPE, selling the corporate-owned stores would also not qualify for discontinued oper-
ations treatment. The corporate-owned stores are likely a component of the company, but the
franchisor is still involved with the franchisees because Eastern Cycles continues to provide
product to them as well as advertising, training, and support. The cash flows of Eastern Cycles
(the franchisor) are still affected by those of the franchisee since Eastern Cycles collects
monthly fees based on revenues.
EXERCISE 3–4
a.
Bunsheim Ltd.
Common Comprehensive Retained Accumulated Other
Total Shares Income Earnings Comprehensive Income
Beginning balance as reported $ 707,000 $480,000 $ 50,000 $177,000
Correction of understatement in
travel expenses from 2019 of
$80,000 (net of tax of $21,600) (58,400) (58,400)
Beginning balance as adjusted $ 648,600 $480,000 $ (8,400) $177,000
Comprehensive income:
Net income 130,853 $130,853 130,853
Other comprehensive Income:
Unrealized gain – FVOCI investments** 25,000 25,000 25,000
Comprehensive income $155,853
Ending balance $ 759,453 $480,000 $ 77,453 $202,000
** net of tax of $5,000. May be reclassified subsequently to net income or loss
Net income = ($680,000 − $425,750 − $75,000) = 179,250 × (1 − 27%) = $130,853

Disclosures – prior period adjustments are to be reported net of tax with the tax amount
disclosed. Unrealized gain on FVOCI investments is to be disclosed net of tax with tax
amount disclosed and that it may be reclassified subsequently to net income or loss.
b.
Bunsheim Ltd.
Balance, January 1, as reported $ 50,000

Correction for understatement in travel expenses
from 2019 of $80,000 (net of tax of $21,600) (58,400)
Balance, January 1, as adjusted (8,400)
Add: Net income 130,853
122,453
Less: Dividends 45,000
Balance, December 31 $ 77,453
EXERCISE 3–5
a.
Patsy Inc.
Partial Statement of Comprehensive Income
Income from continuing operations $1,500,000

Loss from operation of discontinued Calgary
division (net of tax of $52,500) $(122,500)
Loss from disposal of Calgary division
(net of tax of $37,500) (87,500) (210,000)
Net income 1,290,000
Other comprehensive income

Items that may be reclassified subsequently to
net income or loss:
Unrealized gain on FVOCI
investments (net of tax of $11,786*) 27,500
Total comprehensive income $1,317,500
Earnings per share

Income from continuing operations** $ 30.00
Discontinued operations (4.20)
Net income $ 25.80
* (27,500 ÷ (1 − 0.3) = $39,286 before tax. $39,286 − 27,500 = $11,786 tax)

**Continuing operations $1,500,000 ÷ 50,000; discontinued operations ($210,000 ÷ 50,000)
Required disclosures: Items reported at their net of tax amounts must also disclose the
tax amount. Earnings per share information related to income from continuing operations
and discontinued operations are required under IFRS but earnings per share information
related to comprehensive income are not required under IFRS.
b. Had Patsy followed ASPE, other comprehensive income and total comprehensive in-
come do not apply. Investments that are not quoted in an active market are accounted
for at cost. This also assumes that the discontinued operations meet the definition of a
discontinued operation under ASPE.
EXERCISE 3–6
Calculation of increase or (decrease) in shareholders’ equity:
Increase in assets: $41,670 + $15,800 + $218,400 − $46,500 + 14,000 = $243,370

Increase in liabilities: ($23,400) + 45,200 + $46,500 = 68,300
Increase in shareholders’ equity: $175,070
Breakdown of shareholders’ equity account:

Net increase $175,070

Increase in common shares $ 87,000
Increase in contributed surplus 18,600
Decrease in retained earnings due to dividend declaration (44,000) 61,600
Increase in retained earnings due to net income $113,470
To solve algebraically use the basic accounting equation:
Restated:
Change in assets = change in liabilities + change in equity

243,370 = 68,300 + X (equity)
X = 243,370 − 68,300 = $175,070 change in equity
Since equity is made up of common shares+contributed surplus+retained earnings = $175,070

then:
Change in equity − change in common shares − change in contributed surplus + dividends =

change in retained earnings due to net income
175,070 − 87,000 − 18,600 + 44,000 = $113,470
EXERCISE 3–7
$575,000−$75,000 = $7.58 per share

66,000
EXERCISE 3–8
a.
Opi Co.
Income Statement
Revenues
Net sales revenue* $1,778,400
Rent revenue 23,400
Total revenues 1,840,800
Expenses
Selling expenses** 587,600
Administrative expenses*** 130,260
Total expenses 1,738,360
Income before income tax 102,440

Income tax 30,732
Income from continuing operations 71,708
Gain on disposal of discontinued operations –
South Division (net of tax of $8,268) 19,292
Net income $ 91,000
* $1,820,000 − $18,850 − $22,750 = $1,778,400

** $561,600 + $26,000 = $587,600
*** $128,700 + $1,560 = $130,260
Disclosure notes – COGS and most Other Revenue and Expense items are to be dis-
closed separately. Discontinued operations items are to be separately disclosed, net of
tax, with tax amount disclosed.
Opi Co.
Retained earnings, January 1 as reported $338,000

Less error correction (net of tax of $4,050) 9,450
Retained earnings, January 1, as adjusted 328,550
Add: net income 91,000
419,550
Less: dividends 58,500
Retained earnings, December 31 $361,050
Prior period adjustments reported in retained earnings must be separately reported, net
of tax with tax amount disclosed.
b.
Opi Co.
Income Statement
Revenues
Net sales revenue* $1,778,400
Rent revenue 23,400
Expenses
Selling expenses** 587,600
Administrative expenses*** 130,260
Income before income tax 102,440

Income tax 30,732
Discontinued operations:
Gain on disposal of discontinued operations –
South Division (net of tax of $8,268) 19,292
Net income 91,000
Retained earnings, January 1 as reported 338,000
Less error correction (net of tax of $4,050) 9,450
Retained earnings, January 1, as adjusted 328,550
419,550
Less dividends 58,500
Retained earnings, December 31 $ 361,050
* $1,820,000 − $18,850 − $22,750 = $1,778,400

** $561,600 + $26,000 = $587,600
*** $128,700 + $1,560 = $130,260
Disclosure notes – COGS and most Other Revenue and Expense items are to be dis-
closed separately. Discontinued operations items are to be separately disclosed, net of
tax, with tax amount disclosed. Prior period adjustments reported in retained earnings
must be separately reported, net of tax with tax amount disclosed.
EXERCISE 3–9
a.
Ace Retailing Ltd.

Statement of Income
Sales revenue $1,500,000

Less cost of goods sold 750,000
Gross profit 750,000
Less selling and administrative expenses 245,000
Other revenues and gains
Interest income $ 15,000
Gain on sale of FFNI investments 45,000 60,000
565,000
Other expenses and losses
Loss on disposal of equipment 82,000
Loss from warehouse fire 175,000 269,000
Loss from operations, net of income tax recovery of $76,950 208,050
Gain from disposal, net of income taxes of $31,050 83,950 124,100
Net income $ 91,980
Earnings per share

Income from continuing operations* $ 0.34
Discontinued operations** (0.31)
Net income $ 0.03
(rounded)
* ($216,080 − $82,000) ÷ 400,000 = 0.34

** ($124,100) ÷ 400,000 shares = (0.31)
b.
Ace Retailing Ltd.

Statement of Income and Comprehensive Income

Less cost of goods sold 750,000
Less selling and administrative expenses 245,000
Other revenues and gains
Interest income $ 15,000
Gain on sale of FVNI investments 45,000 60,000
565,000
Other expenses and losses
Loss from warehouse fire 175,000 269,000
Loss from operations, net of tax recovery of $76,950 208,050
Gain from disposal, net of tax of $31,050 83,950 124,100
Net income $ 91,980

Unrealized gain on FVOCI investments, net of
income tax of $5,022 13,578
Total comprehensive income $ 105,558
Earnings per share

Net income $ 0.03
(rounded)
* ($216,080 − $82,000) ÷ 400,000 = 0.34

** ($124,100) ÷ 400,000 shares = (0.31)
c.
Ace Retailing Ltd.

Net income $ 91,980

Unrealized gain on FVOCI investments, net of income tax of $5,022 13,578
Total comprehensive income $105,558
d.
Ace Retailing Ltd.
Income Statement
Revenues
Interest income 15,000
Gain on sale of FVNI investments 45,000
Expenses
Cost of goods sold 750,000
Selling and administrative expenses 245,000
Loss from warehouse fire 175,000

Income tax 79,920
Loss from operations, net of income tax recovery of $76,950 208,050
Gain from disposal, net of income taxes of $31,050 83,950
124,100
Net income $ 91,980
Earnings per share

Net income $ 0.03
(rounded)
* ($216,080 − $82,000) ÷ 400,000 = 0.34

** ($124,100) ÷ 400,000 shares = (0.31)
e. Items are to be reported as Other Revenue and Expenses when using the multiple-step
format for the statement of income. These are revenues, expenses, gains, and losses
that are not realized or incurred as part of ongoing operations (for a retail business in
this case). Examples of items that do not normally recur in a retail business are:
• Dividend revenue (from investments)

• Gain or loss on sale or disposal of current or long-term assets (i.e., investments,
property, plant, equipment, and certain intangible assets such as patents and copy-
rights)
• Interest income or expense from receivables or investments
• Impairment losses on various assets not recorded through OCI
• Loss from fire, flood, and storm damages in areas not known for this activity
• Loss on inventory due to decline in NRV

• Rent revenue or other revenues not normally associated with the usual business of
the company
• Unrealized gains or losses on investments not recorded to OCI
Note that as a rule, if the item is unusual and material, (consider size, nature, and
frequency), the item is presented separately but included in income from continuing
operations. If the item is unusual but immaterial, the item is combined with other items
in income from continuing operations. So, there is a trade-off between additional disclo-
sures of relevant information and too much disclosure resulting in information overload.
Moreover, IFRS and ASPE reporting requirements vary and the standards change over
time, so different items may need to be separately reported in one standard but not
necessarily in the other standard. It is important to check the standards periodically to
ensure that the latest reporting requirements are known.
EXERCISE 3–10
Vivando Ltd.
Income Statement (Partial)
Income from continuing operations before income tax $1,891,000*

Income tax 472,750
Income from continuing operations 1,418,250
Loss from operation of discontinued subsidiary
(net of tax of $17,000) $(51,000)
Loss from disposal of subsidiary (net of tax of $28,150) (84,450) 135,450
Net income $ 1,282,800
Earnings per share

Income from continuing operations $ 6.30
Discontinued operations (0.60)
Net income $ 5.70
*Income from continuing operations before income tax:

As previously stated $ 1,820,000
Gain on sale of equipment (92,000 − 33,400 − 75,000) 16,400
Settlement of lawsuit 180,200
Write-off of accounts receivable (125,600)
Restated $ 1,891,000
Note: The prior year error related to the intangible asset was correctly charged to opening
retained earnings.
EXERCISE 3–11
a.
Spyder Inc.
Income Statement
For the Year Ended September 30, 2020
Sales Revenue
Less: Sales discounts $ 21,000
Sales returns and allowances 87,220 108,220
Net sales revenue 2,591,680
Operating Expenses
Selling expenses:
Sales commissions expenses $136,640
Entertainment expenses 20,748
Freight-out 40,502
Telephone and Internet expenses 12,642
Depreciation expense 6,972 217,504
Administrative expenses:
Salaries and wages expenses 78,764
Supplies expense 4,830
Telephone and Internet expense 3,948
Miscellaneous expense 6,601 104,293 321,797
Other Revenues
901,005
Other Expenses
Income tax 262,742
Loss on disposal of discontinued operations –
Aphfflek Division (net of taxes of $14,700) 34,300
Earnings per share from continuing operations $ 4.94*
from discontinued operations (0.28)**
Net income $ 4.66
* $613,063 ÷ 124,000 common shares

** $34,300 ÷ 124,000
b.
Spyder Inc.
Statement of Changes in Shareholders’ Equity
Accumulated
Other
Common Retained Comprehensive
Shares Earnings Income Total
Beginning balance as reported $454,000 $215,600 $162,000 $831,600
Correction of error for depreciation
expense from 2019
(net of tax recovery of $7,434) (17,346) (17,346)
Beginning balance as restated 454,000 198,254 162,000 814,254
Comprehensive income:
Net income 578,763 578,763
Total comprehensive income 578,763 578,763
Dividends – common shares (12,600) (12,600)
Ending balance $454,000 $764,417 $162,000 $1,380,417
c.
Spyder Inc.
Income Statement
Revenues
Net sales revenue $2,591,680
Expenses
Sales commissions expense 136,640
Entertainment expense 20,748
Freight-out 40,502
Telephone and Internet expense* 16,590
Depreciation expense** 17,122
Salaries and wages expense 78,764
Supplies expense 4,830
Miscellaneous operating expense 6,601
Net income from continuing operations before income tax 875,805

Income tax 262,742
Loss on disposal of discontinued operations –
Aphfflek Division (net of taxes of $14,700) 34,300
Earnings per share from continuing operations 4.84***

from discontinued operations (0.28)****
Net income $ 4.56
* $12,642 + $3,948
** $6,972 + $10,150
*** ($613,063 − $12,600) ÷ 124,000 common shares
**** $34,300 ÷ 124,000
d.
Spyder Inc.
Net income $578,763

Unrealized gain on FVOCI investments (net of tax of $7,500) 17,500
Comprehensive Income $596,263
Chapter 4 Solutions
EXERCISE 4–1
Account name Classification

Preferred shares Cap
Franchise agreement IA
Salaries and wages payable CL
Accounts payable CL
Buildings (net) PPE
Investment – Held for Trading CA
Current portion of long-term debt CL
Allowance for doubtful accounts CA
Accounts receivable CA
Bond payable (maturing in 10 years) NCL
Notes payable (due next year) CL
Office supplies CA
Mortgage payable (maturing next year) CL
Land PPE
Bond sinking fund LI
Inventory CA
Prepaid insurance CA
Income tax payable CL
Cumulative unrealized gain or loss from an OCI investment AOCI
Investment in associate LI
Unearned subscriptions revenue CL
Advances to suppliers CA
Unearned rent revenue CL
Copyrights IA
Petty cash CA
Foreign currency bank account or cash CA
EXERCISE 4–2
a.
Aztec Artworks Ltd.

Assets
Current assets
Cash $ 143,000
Investments (held for trading at fair value) 135,000
Accounts receivable $ 332,000
Inventory (at lower of FIFO cost and NRV) $ 960,000
Inventory on consignment 20,000 980,000
Total current assets 1,608,000
Long-term investments:
Investment in bonds (held to maturity at amortized cost) 200,000
Bond sinking fund 100,000
Land held for investment (at cost) 200,000
500,000
Building under construction $ 220,000
Land (at cost) 220,000 440,000
Building (at cost) $1,950,000
Accumulated depreciation (450,000) 1,500,000
Equipment (at cost) 500,000
Accumulated depreciation (120,000) 380,000 2,320,000
Intangible assets:
Patents (net of accumulated amortization for $9,000) 21,000

Current liabilities
Bank indebtedness $ 18,000
Rent payable 120,000
Other payables 35,000
Income tax payable 80,000
Total current liabilities $ 923,000
Long-term liabilities:
Bonds payable (20-year 5% bonds, due August 31, 2025) 800,000
Pension obligation 210,000 1,010,000
Total liabilities 1,933,000
Paid in capital
Preferred, ($2, non-cumulative,participating–authorized
50,000, issued and outstanding, 20,000 shares) $ 900,000
Common (authorized, 900,000 shares; issued and
outstanding 700,000 shares) 700,000
Contributed surplus 430,000 2,030,000
Accumulated other comprehensive income 160,000 2,516,000
1 Cash balance, Dec 31 $ 225,000

Plus bank overdraft 18,000
Less bond sinking fund (100,000)
Adjusted cash balance, December 31 $ 143,000
2 Account receivable, Dec 31 $ 285,000

Plus AFDA 12,000
Plus credit balances to be separately reported 35,000
Adjusted balance, Dec 31 $ 332,000
3 Inventory, Dec 31 $ 960,000

Plus inventory on consignment 20,000
Adjusted balance, Dec 31 $ 980,000
Inventory, net realizable value, Dec 31 985,000
4 Land, Dec 31 $ 420,000

Less land held for investment (200,000)
Adjusted land, Dec 31 $ 220,000
5 Building Equipment
Balance, Dec 31 $1,500,000 $ 380,000
Plus accumulated depreciation 450,000 120,000
Adjusted balance, Dec 31 $1,950,000 $ 500,000
6 Goodwill, Dec 31 $ 190,000

Removed – internally generated goodwill cannot be recognized (190,000)
Adjust balance, Dec 31 $ –
7 Patents, Dec 31 $ 21,000

Accum. amortization for 3 years ($30,000 ÷ 10 × 3 yrs) $ 9,000
Retained earnings = ($501,000 + $20,000 consignment inventory − $190,000 goodwill adjustment −

$5,000 unrealized holding loss for trading investments = $326,000
OR ($4,449,000 − 1,933,000 − 2,030,000 − 160,000) = $326,000
b. Liquidity ratios:
Current ratio = 1,608,000 ÷ 923,000 = 1.74

Quick ratio = (143,000 + 135,000 + 320,000 = 598,000) ÷ 923,000 = 0.65
Activity ratios:
Accounts receivable turnover = 3,000,000 ÷ 320,000

= 9.38 times per year or every 38.9 days (365 ÷ 9.38)
Days’ sales uncollected = 332,000 ÷ 3,000,000 × 365
= 40.4 days
Inventory turnover = (3,000,000 × 60%) ÷ 980,000
= 1.84 times per year or every 198.4 days (365 ÷ 1.84)
Asset turnover = 3,000,000 ÷ 4,449,000
= 0.67 times
Comments:
In terms of liquidity, Aztec’s current ratio of 1.74 suggests at first glance that it can meet
its short-term obligations. However, when inventory and prepaid expenses are removed,
the ratio drops to .65, which is short of the general rule of 1:1 for quick ratios. This may
mean that inventory levels are too high. The inventory turnover ratio below will confirm if
this is the case or not.
Activity ratios, such as the accounts receivable turnover, measure how quickly accounts
are converted into cash. For Aztec, accounts receivable are collected every 38.9 days
on average. Looking at days’ sales uncollected, if a guideline of 30–40 days to collect
is considered reasonable, then Aztec is close to the top end of the 40-day benchmark.
Management would be wise to take steps to improve its receivables collections some-
what.
Inventory turnover of every 200 days or so appears to be very low, which could mean
that too much cash is being tied up in inventory or there is too much obsolete inventory
that cannot be sold. A turnover ratio that is too high can signal inventory shortages that
may result in lost sales. A turnover ratio for each major inventory category will help to
determine if the situation is wide-spread or limited to a particular inventory category.
Asset turnover for .67 times appears low but without industry standard ratios to use as a
comparison benchmark, ratios become less meaningful.
EXERCISE 4–3
a.
Johnson Berthgate Corp.

Assets
Current assets
Cash $ 131,000
Investments (held for trading at fair value) 120,000
Accounts receivable $ 330,000
Inventory (at lower of FIFO cost and NRV) 430,000
Total current assets 1,002,000
Long-term investments:
Investment in bonds (held to maturity at amortized cost) 190,000
Investment, FVOCI 180,000 370,000
Land (at cost) 170,000
Building (at cost) $ 660,000
Equipment (at cost) 390,000
Accumulated depreciation (50,000) 340,000 1,060,000
Intangible assets:
Patents (net of accum. amort. of $80,000 on a straight-line basis) 125,000
Franchise (net of accum. amort. of $45,000 on a straight-line basis) 115,000 240,000
Goodwill 30,000

Current liabilities
Commissions payable 90,000
Unearned consulting fees 13,000
Total current liabilities 583,000
Long-term liabilities:
Bonds payable (20-year 5% bonds, due December 31, 2025) 655,684
Note payable (3%, 5-year, due December 31, 2024) 571,875 1,227,559
Paid in capital
Preferred, ($3, non-cumulative, authorized 1200,
issued and outstanding, 800 shares) $ 80,000
Common (unlimited authorized, issued and
outstanding 260,000 shares) 520,000 600,000
Retained earnings* 236,441
Accumulated other comprehensive income 55,000 891,441
* 290,941 − 90,000 + 20,000 investment trading adj − 10,000 inventory adj + NI of $25,500 = $236,441
Net income = (4,858,000 + 40,000 + 102,000 − 3,050,000 − 11,000 − 8,500 − 135,000 −

1,190,000 − 580,000) = $25,500
b.
Debt ratio = 1,810,559 ÷ 2,702,000 = 67.01%

Equity ratio = 891,441 ÷ 2,702,000 = 32.99%
Nearly 70% of all assets are provided by creditors, which is significant. Digging deeper
and looking at the current ratio for 1.72 (1,002,000 ÷ 583,000), it appears that the current
assets will adequately cover the current liabilities. It follows that the $1.2M in long-
term obligations is the true risk for this company. The company may have to re-finance
the note payable when comes due in 3 more years, or sell off any assets not currently
contributing to profit. Selling off long-term assets is a reasonable step provided that
the assets are idle and will not be used in the foreseeable future to earn profits. This
company’s debt ratio is high, so it has very little financial flexibility.
c. The credit balances in accounts receivable represent amounts owing to specific cus-
tomers. IFRS requires that significant credit balances be separated and reported as a
current liability.
Current ratio without separation of the credit 1,002,000 ÷ 583,000 = 1.72

Current ratio with separation of the credit (1,002,000 + 250,000) ÷ (583,000 +
250,000) = 1.50
Managers may not be aware of the impact that the reporting requirement (to classify
credit receivables as current liabilities) can have on the current ratio. In this case, this
ratio has weakened significantly once the credit amount of $250,000 is reclassified from
a current asset to a current liability. If the company had a restrictive covenant to maintain
a current ratio of 1.7 times, this could spell disaster for the company in two ways. First,
creditors expect a restrictive covenant ratio to be maintained at all times. If this ratio slips
below that threshold, any short-term notes owing to the creditor would become payable
immediately as a demand loan. This would create significant pressure to raise enough
cash in a short period of time to make the single, large payment. Second, if the debt
owing to that creditor also includes any long-term debt, the creditor could also force the
company to reclassify the long-term balances to current liabilities, driving the current
ratio even lower. This might be all that it takes to drive a marginally performing company
into bankruptcy, which is a no-win for either the company or its creditors.
The following are possible conditions or situations that would give rise to a credit balance
in accounts receivable customer accounts.
• Customers returned goods after the account was paid.

• A customer has overpaid an account in error.
• The company policy may be no cash refunds. Any returns would therefore be
credited to the customer account to be used later for a future purchase.
• Most of the accounting software applications apply customer prepayments (un-

earned revenues) as a credit balance in accounts receivable, since eventually the
actual amounts when owed by the customer at the time the goods and services
provided will be debited to the accounts receivable sub-ledger when the invoice is
prepared.
• On the basis of materiality, the credit balances, if insignificant, will likely remain with
the existing accounts receivable as small credit balances.
EXERCISE 4–4
a.
Hughey Ltd.
Assets
Current assets
Cash $ 250,000
Accounts receivable $ 1,015,000
Less allowance for doubtful accounts (55,000) 960,000
Inventory–at lower of FIFO cost and NRV 1,300,000
Prepaid insurance 40,000
Total current assets $2,550,000
Long-term investments
Investments, FVOCI, of which investments
costing $800,000 have been pledged as security
for notes payable to bank 2,250,000
Land 530,000
Building 770,000
Equipment 2,500,000
Accumulated depreciation (1,200,000) 1,300,000 2,300,000
Intangible assets
Patents (net of accumulated amortization of $35,000) 25,000

Current liabilities
7% notes payable to bank, secured by
investments which cost $800,000; $ 600,000
Total current liabilities 1,800,000
Bonds payable, 25-yr, 8%, due December 31, 2030,
at amortized cost 1,100,000
Paid-in capital
Common shares; 100,000 shares authorized,
80,000 shares issued and outstanding 2,500,000
Retained earnings 1,330,000
Accumulated other comprehensive income 395,000* 4,225,000
* Opening balance of $245,000 + $150,000($2,250,000 − 2,100,000) for unrealized holding gain – OCI
on FVOCI investments.
b. Patent annual amortization:

60,000 − 25,000 = 35,000 total amortization for the period January 1, 2015 to December
31, 2021 or 7 years amortized since its purchase.
$35,000 ÷ 7 years = $5,000 per year
c. This company follows IFRS because it has classified and reported some of its invest-
ments as available for sale (OCI) which is a classification only permitted by IFRS com-
panies. ASPE does not have this classification.
EXERCISE 4–5
Description Section Amount

Issue of bonds payable of $500 cash Financing 500
Sale of land and building of $60,000 cash Investing 60,000
Retirement of bonds payable of $20,000 cash Financing (20,000)
Current portion of long-term debt changed from $56,000 to $50,000 Financing *
Repurchase of company’s own shares of $120,000 cash Financing (120,000)
Issuance of common shares of $80,000 cash Financing 80,000
Payment of cash dividend of $25,000 recorded to retained earnings Financing (25,000)
Purchase of land of $60,000 cash and a $100,000 note Investing (60,000)
Cash dividends received from a trading investment of $5,000 Operating 5,000
Interest income received in cash from an investment of $2,000 Operating 2,000
Interest and finance charges paid of $15,000 Operating (15,000)
Purchase of equipment for $32,000 Investing (32,000)
Increase in accounts receivable of $75,000 Operating (75,000)
Decrease in a short-term note payable of $10,000 Operating (10,000)
Increase in income taxes payable of $3,000 Operating 3,000
Purchase of equipment in exchange for a $14,000 long-term note None: non-cash -
* The current portion of long-term debt for both years would be added to their respective long-term debt payable
accounts and reported as a single line item in the financing section.
EXERCISE 4–6
a.
Carmel Corp.
Balance Sheet
Assets
Current assets
Cash $ 247,600
Accounts receivable (net) * 109,040
Total current assets 356,640
Investment in land (at cost) 220,000

Land $200,000
Building (net) 87,200
Equipment (net) 198,000 485,200

Current liabilities
Current portion of long-term debt 32,000
Total current liabilities 87,200
Mortgage payable 110,200
Common shares $470,000
The required disclosures discussed in Chapter 3 that were missed were the AFDA, the
accumulated depreciation for the building and equipment, the interest rate, securitiza-
tion and due date for the mortgage payable classified as a long-term liability, and the
authorized and issued common shares in the equity section.
Calculations Worksheet:
Adjustments
Dr Cr Dr Cr
Cash $ 84,000 1,356,6001 1,193,0002 247,600
Accounts receivable (net) 89,040 1,000,000 980,000 109,040
Investments – trading 134,400 134,400 -
Buildings (net) 340,200 225,000
28,000 87,200
Equipment (net) 168,000 50,000 20,000 198,000
Land 200,000 220,000 420,000
$1,015,640 $1,061,840
Accounts payable $146,000 900,000 809,200 55,200

Mortgage payable 172,200 30,000 142,200
Common shares 400,000 70,000 470,000
Retained earnings 297,440 8,000 105,000 394,440
$1,015,640 2,123,680 $1,061,840
Revenues $1,000,000 A/R 1,000,000

Gain 2,200 2,200
Total revenue 1,002,200
Expenses
Operating expenses 809,200 809,200
Interest expenses 35,000 35,000
Depreciation 48,000 48,000
Loss 5,000 5,000
897,200
Net Income $ 105,000 4,461,800 4,566,800
−105,000 net income

4,461,800 4,461,800 to retained earnings
b.
1
Cash increases due to 980,000 A/R collections, 136,600 proceeds from the sale of the trading investments,
220,000 from the sale of the building and 20,000 from the issuance of additional common shares = 1,356,600
2
Cash decreases due to 900,000 payments of accounts payable, 8,000 payment of cash dividends, 220,000
for additional land, and 65,000 for payments for the mortgage payable = 1,193,000
Carmel Corp.

Adjustments for non-cash revenue and expense
items in the income statement:
Depreciation expense $ 48,000
Gain on sale of investments (2,200)
Loss on sale of building 5,000
Decrease in investments – trading 136,600
Increase in accounts receivable ($109,040 − $89,040) (20,000)
Decrease in accounts payable ($146,000 − $55,200) (90,800) 76,600
Net cash from operating activities 181,600

Proceeds from sale of building ($225,000 − $5,000) 220,000
Purchase of land (220,000)
Net cash from investing activities 0

Reduction in long-term mortgage principal (30,000)
Issuance of common shares 20,000
Payment of cash dividends (8,000)
Net cash from financing activities (18,000)

Cash at beginning of year 84,000
Cash at end of year $ 247,600
Note:
• The purchase of equipment through the issuance of $50,000 of common shares is

a significant non-cash financing transaction that would be disclosed in the notes to
the financial statements.
• Cash paid interest $35,000
Had there been cash paid income taxes, this would also be disclosed.
c. Free cash flow:
Net cash provided by operating activities $ 181,600

Capital purchases – land (220,000)
Cash paid dividends (8,000)
Free cash flow $(46,400)
An analysis of Carmel’s free cash flow indicates it is negative as shown above. Including
dividends paid is optional, but it would not have made a difference in this case. What
does make the difference in this case is that the capital expenditures are those needed
to sustain the current level of operations. In Carmel’s case, the land was purchased
for investment purposes and not to meet operational requirements. The free cash flow
would more accurately be:
Net cash from operating activities $ 181,600

Capital purchases 0
Cash paid dividends (8,000)
Free cash flow $ 173,600
This makes intuitive sense and is supported by the results from one of the coverage
ratios.
The current cash debt coverage provides information about how well Carmel can cover
its current liabilities from its net cash flows from operations:

Average current liabilities
Carmel’s current cash debt coverage is ($181,600 ÷((87,200 + 176,000)× 50%) = 1.38.
The company has adequate cash flows to cover its current liabilities as they come due
and so overall, its financial flexibility looks positive.
In terms of cash flow patterns, Carmel has managed to more than triple its cash balance
in the year mainly from cash generated from operating activities, which is a good trend.
Carmel was able to pay $8,000 in dividends, or a 1.7% return. If dividends are paid
several times throughout the year, the return is more than adequate to investors. Carmel
also sold off its traded investments for a profit and some idle buildings at a small loss to
obtain sufficient internal funding for some land that it wants as an investment. Carmel
also managed to lower its accounts payable levels by close to 60%. All this supports the
assessment that Carmel’s financial flexibility looks reasonable.
d. The information reported in the statement of cash flows is useful for assessing the
amount, timing, and uncertainty of future cash flows. The statement identifies the spe-
cific cash inflows and outflows from operating activities, investing activities, and financing
activities. This gives stakeholders a better understanding of the liquidity and financial
flexibility of the enterprise. Some stakeholders have concerns about the quality of
the earnings because of the various bases that can be used to record accruals and
estimates, which can vary widely and be subjective. As a result, the higher the ratio of
cash provided by operating activities to net income, the more stakeholders can rely on
the earnings reported.
EXERCISE 4–7
Lambrinetta Industries Ltd.

Year Ended December 31, 2021

Adjustments
Depreciation expense* $ 25,500
Change in A/R 27,200
Change in A/P 11,900
Unrealized loss on investments–trading** 5,200
Investments purchased (12,000)
57,800
Net cash from operating activities 219,300

Sold plant assets 37,400
Purchase plant assets*** (130,900)
Net cash from investing activities (93,500)

Note issued**** 42,500
Shares issued for cash (81,600+37,400 in exch for land
– 130,900 ending balance) 11,900
Cash dividends paid***** (188,700)
Net cash from financing activities (134,300)
Net decrease in cash (8,500)

* $136,000 − 13,600 − 147,900

** $81,600 + 12,000 − 88,400
*** $345,100 − 51,000 − 425,000
**** $75,000 + 10,000 − 119,500 − 8,000
***** $314,500 + 161,500 − 287,300
Disclosures:
Additional land for $37,400 was acquired in exchange for issuing additional common shares.
EXERCISE 4–8
a.
Egglestone Vibe Inc.


Net income $ 24,700
Adjustments to reconcile net income to
net cash provided by operating activities:
Depreciation expense (Note 1) $ 55,900
Loss on sale of equipment (Note 2) 10,100
Gain on sale of land (Note 3) (38,200)
Impairment loss–goodwill 63,700
Decrease in accounts payable (28,200) (40,700)
Purchase of investments (FVOCI) (20,000)
Proceeds from sale of equipment 27,300
Purchase of land (Note 4) 62,400
Proceeds from sale of land 150,000
Net cash provided by investing activities 94,900
Cash flows used by financing activities
Payment of cash dividends (Note 5) (42,600)
Issuance of notes payable 10,500
Net cash used by financing activities (32,100)

Note: During the year, $160,000 in notes payable were retired by issuing common
shares.
Notes:
1. $111,800 − $15,600 + X = $152,100; X = 55,900

2. $27,300 − ($53,000 − $15,600)
3. $150,000 − $111,800
4. $133,900 − 111,800 + X = $84,500
5. Retained earnings account: $370,200+ 24,700−X = $374,400; Dividend declared
but not paid = $20,500
Dividends payable account: $41,600 + 20,500 − 19,500 = $42,600 cash paid
dividends
b. Negative cash flows from operating activities may signal trouble ahead with regard to
Egglestone’s daily operations, including profitability of operations and management of
its current assets such as accounts receivable, inventory and accounts payable. All
three of these increased the cash outflows over the year. In fact, net cash provided by
investing activities funded the net cash used by both operating and financing activities.
Specifically, proceeds from sale of equipment and land were used to fund operating
and financing activities, which may be cause for concern if the assets sold were used
to generate significant revenue. Shareholders did receive cash dividends, but investors
may wonder if these payments will be sustainable over the long term. Consider that
dividends declared was $20,500, which was quite high compared to the net income
for $24,700. In addition, the dividends payable account still had a balance payable for
$41,600 from prior dividend declarations not yet paid. All this adds up to increasing the
pressure on the company to find enough funds to catch up with the cash payments to
investors. Egglestone may not be able to sustain payment of cash dividends of this size
in the long term if improvement regarding its profitability and management of receivables,
payables and inventory are not implemented quickly.
Chapter 5 Solutions
EXERCISE 5–1
Scenario 1: Amount to be received = $80 × 36 months = $2,880
Allocate using relative fair values:
Phone: [500 ÷ (500 + (600 × 3))] × 2,880 = 626

Air-time: [(600 × 3) ÷ (500 + (600 × 3))] × 2,880 = 2,254
Therefore, $626 will be recognized immediately and $2,254 will be deferred and recognized
over the 3-year term of the contract.
Scenario 2: Amount to be received = ($100 × 24 months) + $300 = $2,700
Allocate using relative fair values:
Phone: [500 ÷ (500 + (600 × 2))] × 2,700 = 794

Air-time: [(600 × 2) ÷ (500 + (600 × 2))] × 2,700 = 1,906
Therefore, $794 will be recognized immediately and $1,906 will be deferred and recognized
EXERCISE 5–2
Scenario 1: Allocate using residual values:
Phone: 2,880 − (600 × 3) = 1,080

Air-time: 600 × 3 = 1,800
Therefore, $1,080 will be recognized immediately and $1,800 will be deferred and recognized
Scenario 2: Allocate using residual values:
Phone: 2,700 − (600 × 2) = 1,500

Air-time: 600 × 2 = 1,200
Therefore, $1,500 will be recognized immediately and $1,200 will be deferred and recognized
EXERCISE 5–3
Art Attack Ltd. (consignor)
General Journal
Finished goods inventory. . . . . . . . . . . . . . . . . . . 58,000
To segregate consignment goods.

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,200
To record freight.
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67,700
Advertising expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,400
Commission expense . . . . . . . . . . . . . . . . . . . . . . . . . 7,900
Consignment revenue . . . . . . . . . . . . . . . . . . . . . . 79,000
To record receipt of net sales.

Inventory on consignment . . . . . . . . . . . . . . . . . . 48,160
To record COGS: [(58,000 + 2,200) x 80%]
The Print Haus. (consignee)
General Journal
Account receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,400
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,400
To record payment of advertising.
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79,000
To record sales of consigned goods.
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79,000

Revenue from consignment sales . . . . . . . . . . 7,900
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67,700
To record payment to consignor.
EXERCISE 5–4
a.
General Journal
Cash (800 × $3,000) . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400,000
Sales revenue (800 × $3,000 × 99.5%) . . . . 2,388,000
Refund liability (800 × $3,000 × 0.5%) . . . . . 12,000
Cost of goods sold (800 × $2,000 × 99.5%) . . . 1,592,000

Refund asset (800 × $2,000 × 0.5%) . . . . . . . . . . 8,000
Inventory (800 × $2,000). . . . . . . . . . . . . . . . . . . 1,600,000
b.
General Journal
Refund liability (1 × $3,000) . . . . . . . . . . . . . . . . . . . 3,000
Inventory (1 × $2,000). . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000
Refund asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
At the time of sale, it was estimated that 4 desks would be returned during the refund
period (800 × 0.5% = 4). If a further 3 desks are returned before the refund period ends,
journal entries similar to the one above would be made. If the refund period expires and
the number of desks returned differs from the original estimate, the refund asset and
refund liability account will need to be adjusted through net income. As a practical matter,
the company will likely review the balances of the refund asset and liability accounts as
part of the year-end adjustment process.
EXERCISE 5–5
October journal entry:
General Journal
Computer equipment . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000
Unearned revenue . . . . . . . . . . . . . . . . . . . . . . . . . 3,000
Unearned revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
Service revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
November journal entry:
General Journal
Service revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
December journal entry:
General Journal
Service revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 250
EXERCISE 5–6
a. Construction Contract
2020 2021
Costs to date (A) $20,000,000 $ 31,000,000
Estimated costs to complete project 10,000,000 0
Total estimated project costs (B) 30,000,000 31,000,000
Percent complete (C = A ÷ B) 66.67% 100.00%
Total contract price (D) 35,000,000 35,000,000
Revenue to date (C × D) 23,333,333 35,000,000
Less previously recognized revenue - (23,333,333)
Revenue to recognize in the year 23,333,333 11,666,667
Costs incurred the year 20,000,000 11,000,000
Gross profit for the year $ 3,333,333 $ 666,667
b. 2020 Journal Entry:
General Journal

To record billings.
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,000,000

Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,333,333
2021 Journal Entry:

General Journal

To record billings.
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000,000
Construction in progress. . . . . . . . . . . . . . . . . . . . . . . 666,667

Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,666,667
General Journal
Billings on construction . . . . . . . . . . . . . . . . . . . . . . . . 35,000,000
Construction in progress . . . . . . . . . . . . . . . . . . . 35,000,000
To record completion.
EXERCISE 5–7
2021 2022 2023
Costs to date (A) $1,100,000 $ 3,400,000 $ 4,500,000
Estimated costs to complete project 3,200,000 1,000,000 -
Less previously recognized revenue - (1,330,160) (4,018,040)
Revenue to recognize in the year 1,330,160 2,687,880 1,181,960
Costs incurred the year 1,100,000 2,300,000 1,100,000
Gross profit for the year $ 230,160 $ 387,880 $ 81,960
b. Balance Sheet
Current assets
Accounts receivable 300,000*
Recognized contract revenues in excess of billings 718,040**
* calculated as 3,300,000 − 3,000,000 = 300,000

** calculated as (3,400,000 + 230,160 + 387,880) − 3,300,000 = 718,040
Income Statement
Contract revenues 2,687,880

Contract costs 2,300,000
EXERCISE 5–8
2020 2021 2022

Costs to date (A) $ 800,000 $2,400,000 $ 3,900,000
Estimated costs to complete project 2,100,000 1,600,000 -
Revenue to date (C × D) 965,650 2,280,000 3,800,000
Less previously recognized revenue - (965,650) (2,280,000)
Revenue to recognize in the year 965,650 1,314,350 1,520,000
Costs incurred the year 800,000 1,600,000 1,500,000
Gross profit (loss) for the year $ 165,650 (285,650) 20,000
Additional loss to recognize (NOTE) (80,000) 80,000
Gross profit (loss) for the year $ (365,650) $ 100,000
NOTE: Additional loss represents the expected loss on work not yet completed (3,800,000−
4,000,000) × 40% = 80,000
b. Journal Entries
General Journal

To record billings.
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000
Construction expenses* . . . . . . . . . . . . . . . . . . . . . . . 1,680,000

Construction in progress . . . . . . . . . . . . . . . . . . . 365,650
Revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,314,350
* includes actual costs incurred plus additional loss to recognize
EXERCISE 5–9
a. Zero Profit Method
2020 2021 2022

Revenues recognized 800,000 1,600,000 1,400,000
Expenses 800,000 1,800,000 1,300,000
Gross profit (200,000) 100,000
b. Completed Contract Method
2020 2021 2022

Revenues recognized 0 0 3,800,000
Expenses 0 0 3,700,000
Gross profit 0 0 100,000
Loss on unprofitable contract (200,000)
Chapter 6 Solutions
EXERCISE 6–1
a. Cash $600,000
b. Cash equivalent $22,000
c. Cash advance received from customer of $2,670 should be included as a debit to cash
and a credit to a liability account
d. Cash advance of $5,000 to company executive should be reported as a receivable
e. Refundable deposit of $13,000 to developer should be reported as a receivable or a

prepaid expense
f. Cash restricted for future plant expansion of $545,000 should be reported as restricted
cash in noncurrent assets
g. The certificate of deposit of $575,000 matures in nine months so it should be reported

as a temporary investment
h. The utility deposit of $500 should be identified as a receivable or prepaid expense from
the utility company
i. The cash advance to subsidiary of $100,000 should be reported as a receivable
j. The post-dated cheque of $30,000 should be reported as a payment of receivable when

the post-date occurs; until the post-date, the $30,000 is classified as a receivable
k. Details of the $115,000 cash restriction are to be separately disclosed in the balance
sheet with further disclosures in the notes to the financial statements indicating the type
of arrangement and amounts
l. Cash $13,000
m. Postage stamps on hand are reported as part of supplies or prepaid expenses
n. Cash $520,000
o. Cash held in a bond sinking fund is restricted; since the bonds are noncurrent, the
restricted cash is also reported as noncurrent
p. Cash $1,200
q. Cash $13,000
r. Cash equivalent $75,400

s. The NSF cheque of $8,000 should be reported as a receivable
EXERCISE 6–2
a. (Partial SFP):
Current assets
Cash and cash equivalent* $3,385,750
Restricted cash balance 175,000
Non-current assets
Cash restricted for retirement of long-term debt 2,000,000
Current liabilities
Bank indebtedness** 150,000
For Cash and cash equivalent*:
Commercial savings account – First Royal Bank ($575,000 − 175,000) $ 400,000

Commercial chequing account – First Royal Bank 450,000
Money market fund – Commercial Bank of British Columbia 2,500,000
Petty cash 1,500
Cash floats (5 × $250) 1,250
60-day treasury bill** 18,000
Currency and coin on hand 15,000
Cash reported on December 31, 2020 balance sheet as a current asset $3,385,750
** The treasury bill for $18,000 is to be classified as a cash equivalent because the original maturity is less
than 90 days.
*** The bank overdraft at the Lemon Bank for $150,000 is to be reported separately as a current liability
because there are no other accounts at Lemon Bank available for offset.
b. Other items classified as follows:
ii. The minimum balance at First Royal Bank of $175,000 is reported separately as a
restricted cash balance as a current asset cash balance. In addition, a description
of the details of the arrangement should be disclosed in the notes.
vii. The post-dated cheque for $25,000 is for a payment on accounts receivable and
should not be recognized until the cheque is deposited on January 18. It will be
held in a secure location until then.
viii. The post-dated cheque for $1,800 is for unearned revenue and will not be recorded
as unearned revenue until the cheque can be deposited on January 12. It will
be held in a secure location until then. Revenue will be recorded and unearned
revenue offset when legal title to the goods passes to the customer on January 20.
ix. Travel advances for $15,000 are to be reported as prepaid travel.

x. The $2,300 amount paid to the employee is to be reported as a receivable from the
employee. It will be offset when collected from salary in January.
xi. The treasury bill for $50,000 should be classified as a temporary investment (cur-
rent asset). It cannot be reported as a cash equivalent because the original maturity
exceeds 90 days.
xiv. Commercial paper should be reported as temporary investments (current asset).
xv. Investments in shares should be classified with trading securities (current asset) at
their fair value of $4,060 ($4.06 × 1,000 shares).
EXERCISE 6–3
Partial classified balance sheet:
Current assets
Accounts receivable
Customer Accounts (of which accounts in the amount of
$30,000 have been pledged as security for a bank loan) $275,000
Other* ($2,500 + $6,000) 8,500 $283,500
Non-Current Assets
Accounts Receivable
Advance to related company** 30,000
Instalment accounts receivable due after December 31, 2021 50,000
* These items could be separately classified, if considered material.

** This classification assumes that these receivables are not collectible in the near term based on the fact that
they were advanced in 2015 and remain outstanding.
EXERCISE 6–4
a.
General Journal
July 1 Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000
Freight-out (operating expense). . . . . . . . . . . . . . . . 3,200
Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,200
July 5 Sales returns and allowances . . . . . . . . . . . . . . . . . 9,000

(3 × $3,000)
July 10 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109,890

Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,110
For Sales discounts: (($120,000 − 9,000)× 1%)
July 14 Merchandise inventory . . . . . . . . . . . . . . . . . . . . . . . . 79,000

($1,500 × 50 + 4,000)

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112,000
Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224,000
July 26 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110,320

Sales discounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,680
For Sales discounts: ($224,000 × 1.5% × 50%),
for Accounts receivable: ($224,000 × 50%)
Aug 30 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112,000

b. The implied interest rate on accounts receivable paid to Busy Beaver from Heintoch
within the 15-day discount period = 1% ÷ [(30 − 15) ÷ 365] = 24.33%. This means
that Heintoch would be using funds from the bank at a lower rate of 8% to save 24.33%
interest on early payment of amounts owing to Busy Beaver. It is worthwhile to take
advantage of the early payment discount terms in this case.
c.
General Journal
Freight-out (operating expense). . . . . . . . . . . . . . . . 3,200
Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118,800
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,200
For Accounts receivable and Sales revenue:
$120,000 × 99%
July 5 Refund liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,910

($9,000 × 99%)
July 10 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109,890

($118,000 − 8,910)
July 14 Merchandise inventory . . . . . . . . . . . . . . . . . . . . . . . . 79,000

($1,500 × 50 + 4,000)

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112,000
Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220,640
For Accounts receivable and Sales revenue:
$224,000 × 98.5%
July 26 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110,320

Aug 30 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112,000

Sales discounts forfeited . . . . . . . . . . . . . . . . . . . 1,680
Aug 30 Sales revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29,910

Refund liability . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29,910
($23,000 − 8,910 − 44,000)
EXERCISE 6–5
a.
Calculation of cost of goods sold:

Opening inventory $ 35,000
Merchandise purchased 600,000
Less: Ending inventory 225,000
Cost of goods sold $410,000
Sales on account ($410,000 × 1.35) 553,500

Less collections deposited in bank 420,000
Uncollected balance 133,500
Balance per ledger 85,000
Unaccounted for shortage $ 48,500
b. Accounts receivable balance per ledger of $85,000 is less than estimated accounts
receivable of $133,500, suggesting that some accounts receivable collections may have
been received but not actually deposited to the company’s bank account.
Controls to help prevent theft include proper segregation of duties among the person
initially in receipt of the cheque, the person depositing it, and the person recording
the collection. Customers should be encouraged to pay by cheque so an audit trail
is maintained. A timely completion of the monthly bank reconciliation would help detect
if any cash was recorded as collected, but not actually deposited to the company’s bank
account.
EXERCISE 6–6
a.
General Journal
Bad debt expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,340
AFDA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,340
(($225,000 × 4%) + 2,340)
Bad debt expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,995

AFDA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,995
(141,000 × 1% + 53,500 × 3% + 10,500 × 8% +
20,000 × 14%) = 6,655 + 2,340
Bad debt expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,160

AFDA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,160
(($225,000 × 2%) − 2,340)
b. An unadjusted debit balance in the AFDA at year-end is usually the result of write-offs
during the year exceeding the total AFDA opening credit balance. The purpose of the
AFDA is to ensure that the net accounts receivable is valued at net realizable value on
the balance sheet.
EXERCISE 6–7
a.
Balance, January 1, 2020 $ 575,000

Bad debt expense accrual (1% × ($16,000,000 × 0.75)) 120,000
695,000
Uncollectible receivables written off (40,000)
Balance, December 31, 2020, before adjustment 655,000
Allowance adjustment 155,000
Balance, December 31, 2020 $ 500,000
General Journal
Allowance for doubtful accounts . . . . . . . . . . . . . . . 155,000
Bad debt expense . . . . . . . . . . . . . . . . . . . . . . . . . 155,000
b. (Partial classified balance sheet as at December 31)
Current assets
Accounts receivable $50,950,000
Less allowance for doubtful accounts 500,000
Net accounts receivable 50,450,000
The net accounts receivable balance is intended to measure the net realizable value of
the accounts receivable at December 31.
c. The direct write-off approach is not in compliance with GAAP unless the amount of the
write-off is immaterial. Direct write-off does not match (bad debt) expense with revenues
of the period, nor does it result in receivables being stated at estimated net realizable
value on the balance sheet.
EXERCISE 6–8
a.
General Journal
May 1 2020 Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228,676
Services revenue . . . . . . . . . . . . . . . . . . . . . . . . . . 228,676
PV = (0 PMT, 8 I/Y, 5 N, 336000 FV)
Dec 31 2020 Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,196

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,196
($228,676 × 8% × 8 ÷ 12)

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,270
([$228,676 + 12,196] × 8%)

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,811
([$228,676 + 12,196 + 19,270] × 8%)

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,476
([$228,676 + 12,196 + 19,270 + 20,811] × 8%)

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,274
([$228,676 + 12,196 + 19,270 + 20,811 +
22,476] × 8%)
May 1 2025 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 336,000

Notes receivable*** . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,297
Notes receivable*** . . . . . . . . . . . . . . . . . . . . . . . . 336,000
Interest income** . . . . . . . . . . . . . . . . . . . . . . . . . . 8,297
Interest = ([$228,676 + 12,196 + 19,270 +
20,811 + 22,476 + 24,274] × 8%) × 4 ÷ 12
(rounded)
** rounded so that the carrying value was equal to $336,000 at maturity

*** can be netted together into one amount for $327,703 credit
b. Using a financial calculator input the following variables:
Interest = +/- 228676 PV, 0 PMT, 5 N, 336000 FV

= 7.99 or 8% rounded
c. (Partial balance sheet):
Non-current assets
Notes receivable, no-interest-bearing, due May 1, 2025 $260,142*
* $228,676 + 12,196 + 19,270

Unamortized discount as at December 31, 2021, is $336,000 − 260,142 = 75,858.

As at December 31, 2024, the note would be classified as a current asset on the SFP
because the maturity date of May 1, 2025, is within the next fiscal year.
d. The fair value of the services provided can be used to value and record the transaction,
instead of fair value of the note received.
EXERCISE 6–9
a.
Scenario i:
General Journal
July 1 Note receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000
Dec 31 Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000
($120,000 × 5% × 6 months)
Scenario ii:
General Journal
Dec 31 Note receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,625

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,625
($105,000 × 5% × 6 ÷ 12))
Scenario iii:
General Journal
PV = (1 N, 10 I/Y, 115000 FV)

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,227
($104,545 × 10% × 6 months)
b.
Calculate interest from January 1 to July 1:
General Journal
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,228
($104,545 + $5,227 − $115,000)
Calculate the loss from impairment:
General Journal
July 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86,250
Loss on impairment of notes receivable . . . . . . . . 33,750
Note receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115,000
For Cash: (115,000 × 75%)
EXERCISE 6–10
a.
General Journal
Accumulated depreciation – equipment . . . . . . . . 65,400
Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78,000
Gain on sale of equipment . . . . . . . . . . . . . . . . . 878
For Accum. dep.: ($78,000 − $12,600)
PV = (0 PMT, 4 N, 7.5 I/Y, 18000 FV) = $13,478
Fair value of equipment (present value of note) $13,478

Carrying amount 12,600
Gain on sale of equipment $ 878
General Journal
Interest revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,011
First year interest: ($13,478 × 7.5%)
Dec 31 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000

Note receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000
Collection at maturity.
b. Since Harrison uses ASPE, either straight-line or the effective interest method can be
used for recognizing interest income. Below is the calculation using the straight-line
method. Interest income for $1,131 for each of the next four consecutive years will be
recorded.
General Journal
Dec 31 Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,131
Interest Income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,131
First year interest: ($18,000 − 13,478 =
$4,522 ÷ 4 yrs = 1,131)
EXERCISE 6–11
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 472,000
Finance expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,000
Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000
For a. (800,000 × 3.5%)
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 750,000
For b.
Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,375
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509,375
For c. ($500,000 × 7.5% × 3 ÷ 12)
d. To be recorded as a sale under IFRS, both of the following conditions must be met:
i. The transferred assets risks and rewards of ownership have been transferred to the
transferee. This is evidenced by transferring the rights to receive the cash flows
from the receivables. Where the transferor continues to receive the cash flows,
there must be a contractual obligation to pay these cash flows to the transferee
without material delay.
ii. The transferee has obtained the right to pledge or to sell the transferred assets to
an unrelated party (concept of control).
To be recorded as a sale under ASPE, the control over the receivables has been surren-
dered as evidenced by all of the following three conditions being met:
i. The transferred assets have been isolated from the transferor.

ii. The transferee has obtained the right to pledge or to sell the transferred assets.
iii. The transferor does not maintain effective control of the transferred assets through
a repurchase agreement.
e. Management would likely prefer the receivables transfer transaction to be treated as a

sale and derecognized from the accounts rather than a secured borrowing because the
company would not have to record and report the additional debt in the SFP.
EXERCISE 6–12
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500,000
For Loss on sale: ($250,000 − $50,000)
EXERCISE 6–13
a.
General Journal
Feb 1 2020 Cash* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 748,000
Due from Factor** . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000
* $800,000 × (100% − 2.5% + 4%)

** $800,000 × 4%
b. Factoring the accounts receivable will improve the accounts receivable turnover ratio
immediately after recording the entry on February 1 because the average accounts re-
ceivable amount in the denominator will decrease, making the ratio larger. For example,
if sales were $3.2M and accounts receivable before the sale was $1.8M, the turnover
ratio would be 1.78 (3.2M ÷ 1.8M) compared to 3.2 (3.2M ÷ 1M). If the calculation is
made at the December 31 fiscal year-end, the balances of sales and average accounts
receivable would no longer be affected by this transaction, and the accounts receivable
turnover ratio would not be affected. This is because time has passed and many of the
accounts would have been collected by year-end, had the company not sold them to a
factor.
EXERCISE 6–14
a. i. Land in exchange for a note:
General Journal
Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 387,531
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250,000
PV = (0 PMT, 3 N, 11 I/Y, 530,000 FV) = $387,531

ii. Services in exchange for a note:
General Journal
Notes Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330,778
Service Revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . 330,778
Interest payment = $500,000 × 3% = $15,000

PV = (15000 PMT, 6 N, 11 I/Y, 500,000 FV) = $330,778
iii. Partial settlement of account in exchange for a note:
General Journal
Notes receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43,257
PV = (12000 PMT, 5 N, 12 I/Y, 0 FV) = $43,257
b.
Instalment Note Receivable

Cash Interest Amortization Carrying Amount
Payment @ 12% of Note
$43,257 $6,809
Oct 1 – Dec 31 1,298* reduction
Jan 1 – Oct 1 $12,000 3,893** 6,809 36,448 in principal
Oct 1 – Dec 31 1,094
Jan 1 – Oct 1 12,000 3,280 7,626 28,822
Oct 1 – Dec 31 865
Jan 1 – Oct 1 12,000 2,594 8,541 20,281
Oct 1 – Dec 31 609
Jan 1 – Oct 1 12,000 1,825 9,566 10,715
Oct 1 – Dec 31 322
Jan 1 – Oct 1 12,000 964 10,715 –
* $43,257 × 12% × 3 ÷ 12
** $43,257 × 12% × 9 ÷ 12
Note – Some rounding differences will occur when
calculating interest.
General Journal
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,298
Oct 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Note receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,809*
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,893
* See schedule above for the reduction in the principal amount after the first payment was made for
$12,000.
c. From the perspective of Brew It Again, an instalment note reduces the risk of non-
collection when compared to a non-interest-bearing note. In the case of the non-interest-
bearing note, the full amount is due at the maturity of the note. The instalment note
provides a regular reduction of the principal balance in every payment received annually.
This is demonstrated in the effective interest table illustrated above for the instalment
note.
EXERCISE 6–15
a.
Net Credit Sales

Accounts Receivable Turnover =
Average Trade Receivables (net)
$1,022,020*
(Using credit sales) =
($123,000 + $281,760**) ÷ 2
= 5.05 times or about 72 days
* $1,865,000 × 54.8% = 1,022,020

** Opening balance $123,000 + 1,022,020 − 863,260 = 281,760 closing balance. Note
that the write-off of $12,500 does not affect net accounts receivable.
The average receivable is therefore about 72 days old (365 ÷ 5.05).
b. Credit sales are a better measure in the calculation of accounts receivable turnover ratio
since cash sales do not affect accounts receivable balances. On this basis, Petervale
Corporation’s accounts receivable turnover ratio has declined from the previous year.
The average number of days to collect the accounts was 62 days (365 ÷ 5.85) compared
to 72 days for 2020. This could be an unfavourable trend for future liquidity, if customers
continue to pay slowly. Petervale Corporation may want to consider offering discounts
for early payments of accounts or tighten their credit policy.
It should be noted that credit sales are not always available when performing analysis
and calculating the accounts receivables turnover ratio. When not available, the figure of
net sales should be used. As long as the calculation is done consistently between years,
or between businesses, the comparison will remain relevant.
EXERCISE 6–16
a.
Jersey Shores:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,143,750
Due from factor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62,500
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . 1,250,000
For Due from factor: ($1,250,000 × 5%), for
Loss on sale: ($1,250,000 × 3.5%)
Fast factors:
General Journal
Due to customer . . . . . . . . . . . . . . . . . . . . . . . . . . . 62,500
Financing revenue . . . . . . . . . . . . . . . . . . . . . . . . . 43,750
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,142,750
For Due to customer: ($1,250,000 × 5%), for
Financing revenue: ($1,250,000 × 3.5%)
b.
Jersey Shores:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,143,750
Due from factor. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62,500
For Loss on sale: ($43,750 + $7,400)
EXERCISE 6–17
General Journal
July 11 Cash* . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380,000
Loss on sale of receivables** . . . . . . . . . . . . . . . . . . 46,000
Accrued liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000
* $400,000 × 95%
** $400,000×95%−$14,000−$12,000 = $354,000−$400,000 carrying value of accounts receivable = $46,000
Chapter 7 Solutions
EXERCISE 7–1
Inventory would normally include the following items:

• Salaries of assembly line workers
• Raw materials
• Salary of factory foreman
• Heating cost for the factory
• Miscellaneous supplies used in production process
• Costs to ship raw materials from the supplier to the factory
• Electricity cost for the factory
• Depreciation of factory machines
• Property taxes on factory building
• Discounts for early payment of raw material purchases
• Salaries of the factory’s janitorial staff
All of these costs can be considered either direct costs or attributable overhead costs. The
CEO’s and sales team salaries would not be considered costs directly attributable to the
purchase and conversion of inventory.
EXERCISE 7–2
FOB Shipping FOB Destination

Owns the goods while in transit P S
Is responsible for the loss if goods are damaged in P S
transit
Pays for the shipping costs P S
EXERCISE 7–3
a. The company would allocate $150,000 of overhead at the rate of $150,000 ÷ 105,000
= $1.4286 per unit. As a practical matter, the company may choose to simply allocate
based on the standard rate of $1.50 per unit and record a small overhead recovery
through cost of sales. This would be reasonable as the volume produced is close to the
standard volume used to determine the rate.
b. The company would allocate $45,000 of overhead, using the standard rate of $1.50 per
unit. The remaining overhead would need to be expensed. This is necessary to avoid
over-valuing the inventory.
c. The company would allocate $150,000 of overhead at the rate of $150,000 ÷ 160,000
= $0.9375 per unit. The standard rate cannot be used here, as it would over-absorb the
overhead cost into inventory.
EXERCISE 7–4
Date Purchase Sale Balance Balance of

Units
May 1 8 × $550.00 = $4,400 8
May 5 50 × $560.00 (8 × $550.00) + (50 × $560.00) = 58
$32,400
May 8 10 × $575.00 (8 × $550.00) + (50 × $560.00) + 68
(10 × $575.00) = $38,150
May 15 (8 × $550.00)+ (7 × (43 × $560.00) + (10 × $575.00) = 53
$560.00) = $8,320 $29,830
May 22 12 × $572.00 (43 × $560.00) + (10 × $575.00) + 65
(12 × $572) = $36,694
May 25 (23 × $560.00) = (20 × $560.00) + (10 × $575.00) + 42
$12,880 (12 × $572) = $23,814
Cost of Goods Sold for May = (8,320 + 12,880) = $21,200
Ending Inventory on May 31 = $23,814
EXERCISE 7–5
Date Purchase Sale Balance Average Balance of

Cost Units
May 1 8 × $550.00 = $4,400 8
May 5 50 × $560.00 (8 × $550.00) + (50 × 58
$560.00) = $32,400
May 8 10 × $575.00 (8 × $550.00) + (50 × $561.03 68
$560.00) + (10 ×
$575.00) = $38,150
May 15 15 × ($38,150 ÷ 68) = (53 × $561.03) = $561.03 53
$8,415.45 $29,734.55
May 22 12 × $572.00 (53 × $561.03) + (12 × $563.05 65
$572.00) = $36,598.55
May 25 23 × ($36,598.55 ÷ 65) = (42 × $563.05) = $563.05 42
$12,950.15 $23,648.40
Cost of Goods Sold for May = (8,415.45 + 12,950.15) = $21,365.60
Ending Inventory on May 31 = $23,648.40
EXERCISE 7–6
a. No grouping
Description Category Cost ($) Selling LCNRV

Price ($)
Brake pad #1 Brake pads 159 140 140
Brake pad #2 Brake pads 175 180 175
Total brake pads 334 320 315
Soft tire Tires 325 337 325

Hard tire Tires 312 303 303
Total tires 637 640 628
Total LCNRV = (315 + 628) = 943

Current carrying value = ($334 + 637) = 971
Adjustment required = (943 − 971) = (28)
Journal entry required:
General Journal
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
b. With grouping
Description Category Cost ($) Selling LCNRV

Price ($)
Total brake pads 334 320 320
Soft tire Tires 325 337

Hard tire Tires 312 303
Total tires 637 640 637
Only the brake pad category needs to be written down. Total adjustment required =
(320 − 334) = 14
Journal entry required:
General Journal
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
EXERCISE 7–7
NOTE: Positive amounts represent overstatements and negative amounts represent under-
statements.
Item Inventory A/R A/P Net Income

A (82,000) - (82,000)
B (4,000) - (6,000) 2,000
C (27,000) - - (27,000)
D (2,000) 3,500 - 1,500
Total (115,000) 3,500 (6,000) (105,500)
EXERCISE 7–8
a.
General Journal
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82,000
General Journal
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000
General Journal
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27,000
General Journal
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
b. The journal entries would be the same, except any income statement accounts (cost
of goods sold and sales returns) would be replaced with an adjustment to retained
earnings.
EXERCISE 7–9
Inventory on January 1 $ 275,000
Purchases (net of returns) 634,000
Goods available for sale 909,000
Sales $955,000
Less gross profit (35% × $955,000) 334,250
Estimated cost of goods sold 620,750
Estimated inventory on March 4 288,250
Less undamaged goods (90,000 × (1 − 0.35)) (58,500)
Inventory damaged by fire $ 229,750
EXERCISE 7–10
Gross profit margin, by year:

2020: 3,058 ÷ 20,222 = 15.12%

2019: 2,831 ÷ 13,972 = 20.26%
The company’s sales increased significantly between 2019 and 2020. This appears to be a
positive result. The company’s gross profit also increased. However, the gross profit margin
decreased by 5.14%, which represents potential loss profits of approximately $1 billion on the
current sales volume. To investigate further, one should look at budgets and other manage-
ment plans, as well as industry averages and competitor information. It would also be useful
to look at longer trends to see if this decline in profitability is unique to this year or the sign of a
longer term trend. Management explanations of the declining margin percentage, contained in
the annual report, should also be evaluated to determine if the causes relate to slashing sales
prices to increase volumes, increasing cost structures, or some combination of the two. Other
macroeconomic data may also be useful in explaining the change.
Inventory Turnover Period, by year:
2020: [(2,982 + 1,564) ÷ 2 ÷ 17,164] × 365 = 48.34 days

2019: [(1,564 + 1,239) ÷ 2 ÷ 11,141] × 365 = 45.91 days
Inventory turnover has slowed from the previous year, indicating that goods are being held
longer. This is also indicated by the build up of inventory over the three year period. Although
the increased inventory may be reasonable as sales increase, the increase in the turnover
period could create cash flow problems if the trend continues. Again, other comparative data
is needed, such as budgets and industry averages, to evaluate the meaning of this result.
Chapter 8 Solutions
EXERCISE 8–1
a. This investment will be classified as equity investments at cost less any reduction for im-
pairment, because these are equity investments that are not publicly traded. They would
be reported as either current or long-term, depending upon the intention of management
to hold or sell within one year.
b. Journal entries
General Journal
Other investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,500
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,500
(50,000 + (500,000 × 1%))
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,125
Dividend revenue . . . . . . . . . . . . . . . . . . . . . . . . . . 1,125
(500 shares × $2.25)
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,430
Gain of sale of investments (net income) . . . 5,930
Other investments . . . . . . . . . . . . . . . . . . . . . . . . . 50,50
For Cash: (57,000 − (1% × 57,000))
c. To purchase the investment:
General Journal
Investments in shares – FVNI . . . . . . . . . . . . . . . . . 50,000
Brokerage fee expense . . . . . . . . . . . . . . . . . . . . . . . . 500
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,500
For Brokerage fee expense: (500,000 × 1%)
To receive the cash dividends:

General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,125
(500 shares × $2.25)
Year-end adjusting entry to fair value for FVNI investments:
General Journal
Investment in shares – FVNI. . . . . . . . . . . . . . . . . . . 4,000
Unrealized gain on investments (NI) . . . . . . . . 4,000
($108 − $100 × 500 shares)
For sale of investment:

General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56,430
Brokerage fee expense . . . . . . . . . . . . . . . . . . . . . . . . 570
Gain on sale of investments (to net income) 3,000
Investment in shares – FVNI . . . . . . . . . . . . . . . 54,000
For Cash: ($57,000 − 570), for Brokerage
fee expense: (57,000 × 1%), for Investment in
shares: (50,000 + 4,000)
No year-end adjustments are needed under the cost method.
d. Under ASPE, if the shares traded on an active market, they would be classified as a
short-term trading investment at FVNI. The entries would be identical to the ones in part
(c) above, including the adjustment to fair values at year end.
EXERCISE 8–2
a. Using a business calculator present value functions, solve for interest I/Y when the
present value, payment, number of periods and future values are given:
PV = (PMT, I/Y, N, FV)
+/- 25,523PV = 1000 PMT, unknown I/Y, 10 N, 25000 FV = 3.745% (rounded)
b.
Face value of the bond $25,000

Present value of the bond 25,523
Bond premium $ 523
c. Journal entries for a AC investment using amortized cost:
General Journal
Jan 1 2020 Investment in bonds – at amortized cost . . . . . . . 25,523
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,523

Investment in bonds – at amortized cost . . . . 44
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 956
For Investment in bonds: (1,000 − (25,523 ×
3.75%))
Jan 1 2021 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Jan 1 2028 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,250

Investment in bonds – at amortized cost (see 25,121
schedule below or alternative PC calculation) . .
Gain on sale of investment . . . . . . . . . . . . . . . . . 129
For Cash: ($25,000 × 101)
Alternative calculation to the effective interest rate schedule below using a business
calculator and present value functions:
PV = 1000 PMT, 2 N, 3.745 I/Y, 25000 FV = 25,120.68 where N is 2 years left to maturity.
EFFECTIVE INTEREST RATE SCHEDULE
Date Cash Received Interest Income Bond Premium Carrying Value

(4%) (3.745%) Amortization
Jan 1/20 25,523
Jan 1/21 1,000 956* 44 25,479
Jan 1/22 1,000 954 46 25,433
Jan 1/23 1,000 953 47 25,386
Jan 1/24 1,000 951 49 25,337
Jan 1/25 1,000 949 51 25,286
Jan 1/26 1,000 947 53 25,233
Jan 1/27 1,000 945 55 25,178
Jan 1/28 1,000 943 57 25,121 Date of sale
Jan 1/29 1,000 941 59 25,062
Jan 1/30 1,000 938 62** 25,000
Total $10,000 $9,477 $523 25,000
* 25,523 × 3.745%
** rounding
d. Total interest income is $9,477 − 941 − 938 = $7,598 after holding the investment for
eight out of ten years.
Total net cash flows for Smythe is (25,523) cash paid + ($1,000 × 8 years) + 25,250 cash
received upon sale = $7,727 over the life of the investment.
The difference of $129.48 (7,597.52 − 7,727) is the gain on the sale of the investment of
$130 at the end of eight years. (The small difference is due to rounding.)
e. If Smythe followed ASPE, then the investment would be accounted for using amortized
cost. However, in this case, there would be a choice regarding the method used to
amortize the bond premium of $523 calculated in part (b). The choices are straight-line
amortization over the bond’s life or the effective interest rate method shown in part (c).
If the straight-line method was used, then the yearly amortization amount would have
been $523 ÷ 10 years or $52.30 per year for 8 years until the bonds were sold in 2028.
The interest income would be the same over the 8 years.
EXERCISE 8–3
a.
Face value of bond $100,000
Amount paid 88,580
Discount amount $ 11,420
The market value of an existing bond will fluctuate with changes in the market interest
rates and with changes in the financial condition of the corporation that issued the bond.
For example, a 9% bond will become more valuable if market interest rates decrease to
8% because the interest payment is at a higher rate than what investors would receive if
they invested in a market that yielded only 8%.
In this case, the issued bond promises to pay 4% interest for the next 10 years in a
marketplace where interest has now risen to 5.5% for bonds with similar characteristics
and risks. This bond will now become less valuable because the market interest rate has
risen, and investors would receive a higher return in the market than with the 4% bond.
When the financial condition of the issuing corporation deteriorates, the market value of
the bond is likely to decline as well.
b.
General Journal
Jan 2 Investment in bonds – at amortized cost . . . . . . . 88,580
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88,580
Jul 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Investment in bonds – at amortized cost . . . . . . . 436
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,436
For Cash: (100,000 × 4% × 6 ÷ 12), for Interest
income: (88,580 × 5.5% × 6 ÷ 12)

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,448
For Interest income: ([$88,580+ $436]× 5.5%×
6 ÷ 12)
Jan 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

c.
General Journal
Jan 2 Investment in bonds – at amortized cost . . . . . . . 88,580
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88,580
Jul 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Investment in bonds – at amortized cost 571
(11,420 ÷ 20 time periods for interest paid) . . . .
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,571
For Cash: (100,000 × 4% × 6 ÷ 12)

Investment in bonds at amortized cost . . . . . . . . . 571
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,571
Jan 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

EXERCISE 8–4
General Journal
Jul 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,436
For Cash: (100,000 × 4% × 6 ÷ 12), for Interest
income: (88,580 × 5.5% × 6 ÷ 12)
Sept 30 Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,224
For Interest receivable: (100,000× 4% × 3÷ 12),
for Interest income: ([$88,580 + $436] × 5.5% ×
3 ÷ 12)
Jan 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,224
([$88,580 + $436] × 5.5% × 3 ÷ 12)
EXERCISE 8–5
a. Imperial Mark will classify this investment as an investment in bonds – FVNI and will
report the investment as a current asset.
b. Investment purchase:
General Journal
Mar 1 Investment in bonds – FVNI . . . . . . . . . . . . . . . . . . . 20,200
Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 667
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,867
For Investment in bonds: (20,000 × 101), for
Interest receivable: ((20,000 × 5%) × 8 ÷ 12),
for Cash: (20,000 × 101) + unearned interest
from July 1 to Feb 28
Payment of interest using the effective interest rate (IFRS):
General Journal
Jul 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Investment in bonds – FVNI . . . . . . . . . . . . . . . . 5
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328
Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . 667
For Cash: (20,000 × 5%), For Interest income:
(20,200 × 4.87% × 4 ÷ 12)
Interest accrual using the effective interest rate (IFRS):
General Journal
Dec 31 Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 492
For Interest receivable: (20,000 × 5% × 6 ÷ 12),
for Interest income: ((20,200 − 5)× 4.87% × 6 ÷
12)
Fair value adjustment at year-end:
General Journal
Dec 31 Investment in bonds – FVNI . . . . . . . . . . . . . . . . . . . 813
Unrealized holding gain in FVNI bonds . . . . . 813
For Investment in bonds: (21,000 − (20,200 −
5 − 8))
c. If Imperial Mark follows ASPE, it would classify the investment in bonds as Short-Term
Trading Investments, FVNI, and report it as a current investment since management
intends to sell it. The alternate method to amortize the premium is using straight-line
method. The premium to amortize is the face value minus the investment cost over the
life of the bond or (20,000 − 20,200) = 200 ÷ 112 months = 1.79 per month. The
interest income at year-end would be the investment amount at the face rate of interest
minus the premium amortized using SL for that reporting period.
Investment purchase:
General Journal
Mar 1 Investment in bonds – FVNI . . . . . . . . . . . . . . . . . . . 20,200
Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 667
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,867
For Investment in bonds: (20,000 × 101), for
Interest receivable: ((20,000 × 5%) × 8 ÷ 12),
for Cash: (20,000 × 101) + unearned interest
from July 1 to Feb 28
Interest payment using straight-line amortization of premium:
General Journal
Jul 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326
Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . 667
For Cash: (20,000 × 5%), for Investment in
bonds: ($1.79 × 4 months), for Interest income:
((20,000 × 5%) − 7 − 667)
Interest accrual using straight-line method (ASPE):
General Journal
Dec 31 Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489
For Interest receivable: (20,000 × 5% × 6 ÷ 12),
for Investment in bonds: ($1.79 × 6 months), for
Interest income: (500 − 11)
Fair value adjustment at year-end:
General Journal
Dec 31 Investment in bonds – FVNI . . . . . . . . . . . . . . . . . . . 818
Unrealized holding gain in FVNI bonds . . . . . 818
(21,000 − (20,200 − 7 − 11))
EXERCISE 8–6
a. Halberton would classify this as an investment in shares – FVOCI equities, without

recycling, which is a special irrevocable election. Even though it may be for sale, there
is no specific intention as to exactly when it will be sold, so it does not fit the business
model for shares that are being actively traded. The investment will be reported as a
long-term asset because it is unknown when it will be sold.
b. Purchase of investment:
General Journal
Investment in shares – FVOCI . . . . . . . . . . . . . . . . . 52,800
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52,800
Dividend payment:
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500
(1,000 × $2.50)
Fair-value adjustment through OCI:
General Journal
Unrealized loss on FVOCI investments – OCI . . 2,800
Investment in shares – FVOCI . . . . . . . . . . . . . 2,800
((1,000 × $50) − 52,800)
The drop in price is not due to investment impairments, it is due to market fluctuations.
For this reason, it is a fair value adjustment through OCI. Had the credit risk for this
investment increased due to increased expected defaults, management would have
revised the ECL and adjusted the investment and loss accounts (to net income due
to impairment) accordingly.
c. Sale entries – step 1 – first, record the fair value change to the investment and OCI:
General Journal
Investment in shares – FVOCI . . . . . . . . . . . . . . . . . 4,200
Unrealized gain on FVOCI investments – 4,200
OCI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
(54,200 − 50,000)
Step 2 – record the cash proceeds and remove the investment:

General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54,200
NOTE – steps 1 and 2 can be combined as shown in the chapter illustrations. They have
been separated here for illustration purposes. Either method is acceptable.
Step 3 – remove the OCI amount that related to the investment sold:
General Journal
AOCI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400
(54,200 − 52,800)
To reclassify investment sold from AOCI to
retained earnings.
d. If Halberton followed ASPE, this investment would likely be classified as a short-term

trading investment with fair value adjustments at each reporting date, since the invest-
ment for shares appears to have active market prices and the investment is for sale
(though no specific intention to sell exists at the moment). If the shares were not publicly
traded, then the investment would likely be classified as an Other Investment – at cost,
with no fair value adjustments.
EXERCISE 8–7
General Journal
Feb 1 Investment – FVNI – Xtra bonds . . . . . . . . . . . . . . . 532,500
Interest receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 552,500
a. For Interest receivable: (500,000 ×
12% × 4 ÷ 12), for Cash: (532,500 +
accrued interest 20,000)
Apr 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000

Investment – Xtra bonds . . . . . . . . . . . . . . . . . . . 1,125
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,875
b. For Cash: (500,000 × 12% × 6 ÷ 12), for
Interest income: (532,500 × 10% × 2 ÷ 12)
Jul 1 Investments – FVNI – Vericon bonds . . . . . . . . . . 202,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203,500
c. For Investments in Vericon bonds:
(200,000 × 101), for Interest receivable:
($200,000 × 9% × 1 ÷ 12)
Aug 12 Investments – FVNI – Bretin ACT shares . . . . . . 177,000

Brokerage fee expense . . . . . . . . . . . . . . . . . . . . . . . . 1,770
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178,770
d. For Investments in Bretin ACT shares:
(3,000 × $59)
General Journal
Sept 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109,000
Loss on sale of investment . . . . . . . . . . . . . . . . . . . . 1,703
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,428
Investments – FVNI – Xtra Corp. bonds . . . . 106,275
e. For Cash: (($100,000 × 104) + (100,000 ×
12% × 5 ÷ 12)), for Investments in Xtra Corp.
bonds: (532,500−1,125×(100,000÷500,000)),
for Loss on sale: ((532,500 − 1,125) ×
20% = 106,275 carrying value to Apr 1 −
(5,000 − 4,428)), for Interest income:
(532,500 − 1,125 amort = 531,375 CV ×
5% semi-annual market rate × 20% ×
5/6 months from Apr 1 to Sept 1 = 4,428)
Sept 28 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

f. For Cash: (3,000 × $0.50)
Oct 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,255
Investment – Xtra bonds . . . . . . . . . . . . . . . . . . . 2,745
g. For Cash: ($400,000 × 12% × 6 ÷ 12), for
Interest income: ((532,500 − 1,125 − 106,275)×
10% × 6.12)
Dec 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000

Investment – Vericon bonds . . . . . . . . . . . . . . . . 346
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,154
h. For Cash: ($200,000 × 9% × 6 ÷ 12), for
Investment in Vericon bonds: (9,000 − 1,500 −
7,154), for Interest income: (202,000 × 8.5% ×
5 ÷ 12)
Dec 28 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,560

i. (3,000 × $0.52)
Dec 31 Investments – Bretin ACT shares . . . . . . . . . . . . . . 4,500

Unrealized gain on FVNI investments (net 4,500
income) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
j. ($181,500 FV − $177,000)
Dec 31 Interest receivable∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Investments – Xtra bonds . . . . . . . . . . . . . . . . . . 1,441
Interest income∗∗ . . . . . . . . . . . . . . . . . . . . . . . . . . 10,559
j. To accrue interest income to Dec 31
∗
(400,000 × 12% × 3 ÷ 12)
∗∗
(532,500 − 1,125 − 106,275 − 2,745 =
422,355 × 10% × 3 ÷ 12)
General Journal
Dec 31 Unrealized loss in Xtra bonds . . . . . . . . . . . . . . . . . . 13,914
Investments – Xtra bonds . . . . . . . . . . . . . . . . . . 13,914
j. To adjust to fair value
(422,355 − 1,441 = 420,914 CV − (400,000 ×
1.0175))
Dec 31 Interest receivable∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Investments – Vericon bonds . . . . . . . . . . . . . . . 72
Interest income∗∗ . . . . . . . . . . . . . . . . . . . . . . . . . . 1,428
j. To accrue interest income to Dec 31
∗
(200,000 × 9% × 1 ÷ 12)
∗∗
(202,000 − 346) = 201,654 × 8.5% × 1 ÷ 12
Dec 31 Unrealized loss in Vericon bonds . . . . . . . . . . . . . . 7,582

Investments – Vericon bonds . . . . . . . . . . . . . . . 7,582
j. To adjust to fair value
(202,000 − 346 − 72) = 201,582 CV −
(200,000 × 0.97)
NOTE – An alternative treatment is to debit interest income at the date of purchase of the
bonds instead of interest receivable. This procedure is correct, assuming that when the cash
is received for the interest, an appropriate credit to interest income is recorded. Consistency
is key.
EXERCISE 8–8
a. Verex follows IFRS because only IFRS companies can account for investments using
the FVOCI classification. In this case, the FVOCI is without recycling because these are
equities.
b. Purchase of investment:
General Journal
Jan 1 Investment in shares – FVOCI . . . . . . . . . . . . . . . . . 136,750
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136,750
(135,000 + 1,750)
Cash dividend declared:

General Journal
Oct Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,400
(140,000 × 10% × $1.10)
Year-end fair value adjusting entry:
General Journal
Dec 31 Investment in shares – FVOCI . . . . . . . . . . . . . . . . . 450
Unrealized gain in FVOCI investment – OCI 450
(137,200 − 136,750)
Sale entries – step 1 – first, record the fair value change to the investment and OCI:
General Journal
Feb 1 Investment in shares – FVOCI . . . . . . . . . . . . . . . . . 14,820
Unrealized gain on FVOCI investments – 14,820
OCI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
(7,000 × $12 − $580) − (7,000 × 9.80)
Step 2 – record the cash proceeds and remove the investment:
General Journal
Feb 1 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83,420
(7,000 × $12) − $580
Step 3 – reclassify the OCI amount related to the investment sold from AOCI to OCI:
General Journal
Feb 1 AOCI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,045
((450 × 50%) + 14,820)
NOTE – steps 1 and 2 are combined in the chapter illustrations. They have been
separated here for illustration purposes.
EXERCISE 8–9
Other Comprehensive Income (OCI) = unrealized holding gain in FVOCI investments = $350,000−
320,000 = $30,000
Comprehensive Income (CI) = net income + OCI = $250,000 + 30,000 = $280,000

Accumulated Other Comprehensive Income (AOCI) = AOCI opening balance + OCI = $15,000+
30,000 = $45,000
EXERCISE 8–10
Entry for impairment:
General Journal
Jan 4 2021 Loss on impairment . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Investment in bonds – at amortized cost . . . . 5,000
($200,000 − 195,000)
Note: For ASPE, the impaired value is the higher of the discounted cash flow using the current
market interest rate and the net realizable value (NRV) either through sale or by exercising the
company’s rights to collateral. Since the NRV information is not available, the discounted cash
flow using the current market interest rate is the measure used to determine impairment.
Entry for impairment recovery:
General Journal
Jun 30 2021 Investment in bonds – at amortized cost . . . . . . . 5,000
Recovery of loss on impairment . . . . . . . . . . . . 5,000
EXERCISE 8–11
a.
General Journal
Investment in shares – FVNI. . . . . . . . . . . . . . . . . . . 5,900
Unrealized gain on shares . . . . . . . . . . . . . . . . . 5,900
(15,000+24,300+75,000)−(17,500+22,500+
80,200)
b.
General Journal
2021 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,000
Gain on the sale of shares . . . . . . . . . . . . . . . . . 2,400
Investment in shares – Warbler. . . . . . . . . . . . . 22,500
Investment in shares – Shickter – 50% . . . . . 40,100
For Cash: (23,000 + 42,000)
c.
General Journal
Dec 31 2021 Investment in shares – FVNI. . . . . . . . . . . . . . . . . . . 2,600
Unrealized gain on shares . . . . . . . . . . . . . . . . . 2,600
(17,500 + 40,100) − (19,200 + 41,000)
d. If Camille followed ASPE, these equity investments would be classified as FVNI since
there appears to be an active market for these shares. The entries would be the same
as those shown for parts (a), (b), and (c). No impairment measurements are required
since the investments are already accounted for using fair values.
EXERCISE 8–12
a.
General Journal
Sept 30 2019 Investments in bonds – FVNI . . . . . . . . . . . . . . . . . . 225,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233,250
12)
Oct 31 2019 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 750
For Cash: (225,000 × 4%)

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
Investments in bonds – FVNI . . . . . . . . . . . . . . . . . . 5,850
Unrealized gain on investments (net income) 5,850
12), for Unrealized gain: ((225,000 × 102.6) −
225,000)
Mar 1 2020 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 234,300

Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
Investment in bonds – FVNI . . . . . . . . . . . . . . . . 230,850
Gain on sale of bonds. . . . . . . . . . . . . . . . . . . . . . 450
For Cash: (225,000 × 102.8 + 3,000), for
Interest income: (225,000 × 4% × 2 ÷ 12), for
Investment in bonds: ($225,000 + 5,850)
b.
Partial balance sheet

Current assets
Interest receivable $ 1,500
Investments in bonds – FVNI (225,000 + 5,850) 230,850
Partial income statement

Other income
Interest income (750 + 1,500) $2,250
Unrealized gain on FVNI investments 5,850
c. ASPE requires separate reporting of interest income from net gains or losses recognized
on financial instruments (CPA Canada Handbook, Part II, Accounting Standards for
Private Enterprises, Section 3856.52) whereas IFRS can choose to disclose whether the
net gains or losses on financial assets measured at fair value and reported on the income
statement include interest and gains or losses, but it is not mandatory. (For purposes of
this text, the preferred treatment for either standard is to separate unrealized gains/loss,
interest income and dividend income separately since some of the information is required
when completing the corporate tax returns for either ASPE or IFRS companies.)
d. The overall returns generated from the bond investment was $10,050, calculated as
follows:
Interest Oct 31, 2019 $ 750

Interest accrued Dec 31, 2019 1,500
Unrealized gain to Dec 31, 2019 5,850
Interest accrued Mar 1, 2020 1,500
Gain on sale of bonds Mar 1, 2020 450
Total investment returns (income and gains) 10,050
This return represents a 10.72% annual return on the investment [($10,050 ÷ 5 months ×
12) ÷ $225,000]. This return is more than anything the company might be able to earn
in a typical savings account.
EXERCISE 8–13
a. December 31, 2020 entry:
General Journal
Bond investment at amortized cost . . . . . . . . . 22,000
($422,000 − $400,000)
Under ASPE, the carrying amount is reduced to the higher of the discounted cash flow
using a current market rate or the bond’s net realizable value NRV. Impairment reversals
are permitted under ASPE for both debt and equity instruments.
b. December 31, 2020 entry:
General Journal
Allowance for bond investment impairment . 22,000
($422,000 − $400,000)
The investment account remains at its current carrying amount and it is offset by the
credit balance in the asset valuation allowance account.
EXERCISE 8–14
a.
Purchase of bonds:
General Journal
Jan 1 2020 Investment in bonds – FVNI . . . . . . . . . . . . . . . . . . . 236,163
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 236,163
Present value calculation: PV = (20000 PMT, 8
N, 9 I/Y, 250000 FV) = $236,163
Interest payment:
General Journal
Dec 31 2020 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Investment in bonds – FVNI . . . . . . . . . . . . . . . . . . . 1,255
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,255
(236,163 × 9%)
Fair value adjustment:

General Journal
Dec 31 2020 Investment in bonds – FVNI . . . . . . . . . . . . . . . . . . . 2,582
Unrealized gain on investment (net income) 2,582
(236,163 + 1,255) = 237,418 carrying value −
240,000 fair value = 2,582
Interest payment:
General Journal
Dec 31 2021 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,368
(236,163 + 1,255 = 237,418 × 9%)

General Journal
Dec 31 2021 Unrealized loss on investment (net income) . . . . 23,118
Investment in bonds – FVNI . . . . . . . . . . . . . . . . 23,118
(236,163 + 1,255 + 2,582 + 1,368 =
241,368 carrying value − (250,000 ×
87.3) market value = 23,118
Interest payment:
General Journal
Dec 31 2022 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,491
(236,163 + 1,255 + 1,368 = 238,786 × 9%)
General Journal
Unrealized gain on investment . . . . . . . . . . . . . 11,009
(236,163 + 1,255 + 2,582 + 1,368 − 23,118 +
1,491) = 219,741 carrying value − (250,000 ×
Interest payment:
General Journal
Dec 31 2023 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Interest income . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,625
(236,163 + 1,255 + 1,368 + 1,491 = 240,277 ×
9%)
General Journal
Unrealized gain on investment . . . . . . . . . . . . . 15,875
(236,163 + 1,255 + 2,582 + 1,368 −
23,118 + 1,491 + 11,009 + 1,625) =
232,375 carrying value − (250,000 ×
b. Part (a) uses a fair values to measures for FVNI investments and are re-measured to
their FV at each year-end. No, separate impairment measurement if required because
they are already at their fair values. If Helsinky had accounted for this investment at
amortized cost, the impairment model would change to an incurred loss model. When
there is objective evidence that the expected future cash flows have been significantly
reduced, an impairment loss is measured and recognized as follows:
The loss is measured as the difference between the carrying amount and
higher of the present value of the revised expected cash flows, discounted at
the current market discount rate and the estimated net realizable value of the
investment.
The impairment losses can be reversed if the investment values increase.
EXERCISE 8–15
a. Dec 31, 2019: No entry as there was no trigger or loss event in 2019.
General Journal
Dec 31 2020 Loss on impairment . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,500
Other investments . . . . . . . . . . . . . . . . . . . . . . . . . 37,500
($87,500 − 50,000)
b.
General Journal
Dec 31 2019 Unrealized Gain or Loss (net income). . . . . . . . . . 5,000
Investments – FVNI . . . . . . . . . . . . . . . . . . . . . . . . 5,000
($34 − $32) × 2,500 shares
Dec 31 2020 Unrealized Gain or Loss (net income). . . . . . . . . . 17,500

($32 − $25) × 2,500 shares
c. For in investment in equities classified as FVOCI, there are no impairment evaluations

required because the investment is remeasured to its fair value each reporting date
and the gains/losses upon sale are reclassified from AOCI to retained earnings. Had
the investment been a debt investment and classified as FVOCI, such as bonds, an
impairment evaluation would be required initially upon acquisition and based on either
a 12-month or lifetime ECL valuation. This is because the gains/losses are recycled
through net income upon sale. Any impairment loss would be immediately recorded to
net income in this case and not to OCI.
EXERCISE 8–16
a. Since Yarder’s shares were quoted in an active market, Sandar is required to apply the
FVNI classification to account for its investment. If the shares were not quoted in an
active market, the cost method would have been required.
FVNI – where the shares are traded in an active market:
General Journal
Jan 1 2020 Investments – FVNI . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000
(50,000 × 32%) = 16,000 shares × $25
Jun 30 2020 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,200

($60,000 × 32%)
Dec 31 2020 Unrealized gain or loss . . . . . . . . . . . . . . . . . . . . . . . . 32,000

($25 − 23) × 16,000 shares
b. Cost method – where there is no active market for the shares:
General Journal
Jan 1 2020 Other investments – at cost . . . . . . . . . . . . . . . . . . . . 400,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000
(50,000 × 32%) = 16,000 shares × $25
Jun 30 2020 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,200

($60,000 × 32%)
Dec 31, 2020: No entry required.
c. Equity method:
General Journal
Jan 1 2020 Significant influence investments . . . . . . . . . . . . . . 400,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000
(50,000 × 32%) = 16,000 shares × $25
Jun 30 2020 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,200

Significant influence investments . . . . . . . . . . . 19,200
($60,000 × 32%)
Dec 31 2020 Significant influence investments . . . . . . . . . . . . . . 38,400

Investment income or loss . . . . . . . . . . . . . . . . . 38,400
($120,000 × 32%)
NOTE: Even though Sandar has significant influence over the operations of Outlander,
companies that follow ASPE have a choice between the equity method and the held-for-
trading (active market), or the equity method and the cost method (no active markets).
EXERCISE 8–17
a. Investee’s total net income = $60,000 ÷ 30% = $200,000
b. Investee’s total dividend payout = $200,000 × 15% = $30,000
c. Investor’s share of net income = $200,000 × 30% = $60,000
d. Investor’s annual depreciation of the excess payment for net capital assets is the only
other credit amount recorded in the T-account for $1,500
e. Goodwill = $900,000 × 30% = 270,000 − 290,000 = 20,000 − (1,500 × 10 years) =

5,000 to goodwill
f. Investor’s share of dividends = $30,000 × 30% = $9,000
EXERCISE 8–18
a. 2019:
General Journal
Investments – FVNI . . . . . . . . . . . . . . . . . . . . . . . . . . . 380,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500
Dividend Revenue (net income) . . . . . . . . . . . . 7,500
($25,000 × 0.30)
Investments – FVNI . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Unrealized Gain or Loss (net income) . . . . . . 20,000
($400,000 − $380,000)
2020:
General Journal
Unrealized Gain or Loss (net income). . . . . . . . . . 40,000
($400,000 − 360,000)
b. Recall that comprehensive income is:

Net income + Other Comprehensive Income (i.e., unrealized fair value gains/losses from
FVOCI investments) = Comprehensive Income
With this in mind, comprehensive income will be the same amount as net income be-
cause there is no Other Comprehensive Income (OCI) amount to report as the invest-
ment is classified as FVNI with unrealized gains and losses due to fair value adjustments
being recorded to net income. Had the investment been classified as FVOCI, then the
$20,000 fair value change would have been reported as OCI and not in net income, thus
increasing comprehensive income by $20,000 more than net income in 2019, and by
$40,000 in 2020.
c. 2019:
General Journal
Investment in associate. . . . . . . . . . . . . . . . . . . . . . . . 380,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,500
Investment in associate . . . . . . . . . . . . . . . . . . . . 7,500
($25,000 × 0.30)

($50,000 × 0.30)
Investment income or loss . . . . . . . . . . . . . . . . . . . . . 2,000

($380,000 − 360,000 = 20,000 ÷ 10 years)
NOTE: there is no entry to adjust the investment to its fair value under the equity method.
2020:
General Journal
($15,000 × 0.30)

NOTE: there is no entry to adjust the investment to its fair value under the equity method.
d. Carrying amount of the investment:

Cost $380,000
Dividend received in 2019 (7,500)
Income earned in 2019 (15,000 – 2,000) 13,000
Loss incurred in 2020 (4,500 + 2,000) (6,500)
Carrying amount at December 31, 2020 $379,000
Fair value of investment at December 31, 2020 $360,000
e. For part (c), if the investee had reported a loss from discontinued operations, all entries
would stay the same except for the entry recording the 2019 share of income. This entry
would change to reflect the investor’s share of the loss from discontinued operations sep-
arately from its share of the loss from continuing operations because separate reporting
of discontinued operations is a reporting requirement for IFRS and ASPE.
2019:
General Journal
Investment loss – loss on discontinued opera- 4,500
tions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
For Investment in associate: (50,000 × 30%),
for Investment loss: (15,000 × 30%)
Income Statement details:
Income from continuing operations $ 65,000

Loss from discontinued operations (15,000)
Net income $ 50,000
EXERCISE 8–19
General Journal
Significant influence investment . . . . . . . . . . . . . . . 600,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000
Cost of 35% investment $600,000

Carrying values:
Assets ($900,000 + 780,000) $1,680,000
Liabilities 225,000
1,455,000
× 35% 509,250
Excess paid over share of carrying value $ 90,750
Excess of $90,750 allocated to:
Assets subject to amortization

[($1,050,000 − $900,000) × 35%] 52,500
Residual to goodwill 38,250
$90,750
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000
Significant influence investment . . . . . . . . . . . . 35,000
($100,000 × 0.35)
Significant influence investment . . . . . . . . . . . . . . . 78,750

($225,000 × 0.35)

Significant influence investment . . . . . . . . . . . . 5,250
($52,500 ÷ 10)
EXERCISE 8–20
a) ASPE b) IFRS
i. FVNI since an active market exists. No FVOCI without recycling, with unrealized
separate impairment evaluation needed gain/loss through OCI since there is no
since investment is adjusted to fair value. specific intention to sell for trading pur-
poses. No separate impairment evalua-
tion needed since investment is adjusted
to fair value and not recycled through net
income.
ii. Other investment in equities at cost, since FVOCI without recycling, with unrealized
no active market exists. No fair value gain/loss through OCI since there is a
adjustments are done. Impairment adjust- long-term strategy regarding this invest-
ment is possible if a trigger event occurs. ment. No separate impairment evaluation
Impairment reversal is possible. When needed since investment is adjusted to
30% is obtained, management will need fair value and not recycled through net
to re-measure. income. When 30% is obtained, manage-
ment will need to reclassify to investment
in associates, if significant influence ex-
ists.
iii. Other investment at amortized cost since Amortized cost since this investment has
the intention was to originally hold to been accounted for since the initial pur-
maturity. No fair value adjustments are chase at amortized cost. Impairment eval-
done. Impairment adjustment is possible uation is done based on an assessment of
if a trigger event occurs. Impairment probability-based estimated default sce-
reversal is possible. narios and +/- adjustments going forward
until bond has matured.
iv. Other investment in equities at cost. The Likely FVOCI without recycling with unre-
FV of the shares is not a factor as alized gain/loss through OCI since there
they are being held to improve business is no intention to actively trade them. No
relations. No fair value adjustments are separate impairment evaluation needed
done. Impairment adjustment is possible since investment is adjusted to fair value
if a trigger event occurs. Impairment and not recycled through net income.
reversal is possible.
v. FVNI since the bonds trade on the market. FVNI. No separate impairment evaluation
Management intent is to sell as soon as needed since investment is adjusted to
the market price increases. No separate fair value.
impairment evaluation needed since in-
vestment is adjusted to fair value.
vi. Other investments at amortized since the At amortized cost since this investment
intention is to hold to maturity. No fair will be held until maturity. Impairment
value adjustments are done. Impairment evaluation is done based on an assess-
adjustment is possible if a trigger event ment of probability-based estimated de-
occurs. Impairment reversal is possible. fault scenarios and +/- adjustments going
forward until bond has matured.
a) ASPE b) IFRS
vii. FVNI since management intends to sell FVNI since management intent is to sell
them within one year. No separate impair- within one year. No separate impairment
ment evaluation needed since investment evaluation needed since investment is
is adjusted to fair value. adjusted to fair value.
EXERCISE 8–21
The intent is to hold the investment and to collect interest and principal until maturity, so the
classification should be amortized cost.
General Journal
Loss on impairment (NI) . . . . . . . . . . . . . . . . . . . . . . . 1,725
Investment in bonds, amortized cost . . . . . . . 1,725
(1,150,000 × 0.01 × 0.15) = 1,725 ECL over the next 12 months
Carrying value of the investment in bonds is (1,150,000 − 1,725) = $1,148,275
EXERCISE 8–22
General Journal
(1,150,000 × 0.06 × 0.50) = 34,500 ECL over the investment’s lifetime

1,150,000 − 34,500 = 1,115,500 probability-based fair value − 1,148,275 carrying value =
32,775 impairment
Carrying value of the investment in bonds is therefore 1,115,500.
The ECL increase is deemed to be significant by management and as a result, the ECL has
changed from a 12-month ECL to the investment’s lifetime (Lifetime ECL).
EXERCISE 8–23
General Journal
Unrealized gain/loss (OCI). . . . . . . . . . . . . . . . . . . . . 4,025
For Unrealized gain/loss: (1,150,000 × (1 −
0.995) = 5,750 − 1,725)
Chapter 9 Solutions
EXERCISE 9–1
The following costs should be capitalized with respect to this equipment:
Cash price paid, net of $1,600 discount, excluding $3,900 of recoverable tax $ 78,400
Freight cost to ship equipment to factory 3,300
Direct employee wages to install equipment 5,600
External specialist technician needed to complete final installation 4,100
Materials consumed in the testing process 2,200
Direct employee wages to test equipment 1,300
Legal fees to draft the equipment purchase contract 2,400
Government grant received on purchase of the equipment (8,000)
Total cost capitalized 89,300
The recoverable tax should be disclosed as an amount receivable on the balance sheet.
The repair costs, costs of training employees, overhead costs, and insurance cost would all be
expensed as regular operating expenses on the income statement.
An alternative treatment for the government grant would be to defer it as an unearned revenue
liability and then amortize it on the same basis as the equipment depreciation.
EXERCISE 9–2
The following costs would be capitalized with respect to the mine:

Direct material $2,200,000

Direct labour 1,600,000
Interest (3,000,000 × 8% × 9 ÷ 12) 180,000
Less interest on excess funds (30,000)
Present value of restoration costs (FV=100,000, I=10, N=10) 38,554
Total cost capitalized 3,988,554
EXERCISE 9–3
With a lump sum purchase, the cost of each asset should be determined based on the relative
fair value of that component. The total fair value of the asset bundle is $250,000. Therefore,
the allocation of the purchase price would be as follows:
Specialized lathe (30,000 ÷ 250,000) × 220,000 = 26,400

Robotic assembly machine (90,000 ÷ 250,000) × 220,000 = 79,200
Laser guided cutting machine (110,000 ÷ 250,000) × 220,000 = 96,800
Delivery truck (20,000 ÷ 250,000) × 220,000 = 17,600
Total 220,000
EXERCISE 9–4
a.
Prabhu
General Journal
New equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,000
Accumulated depreciation – old equip. . . . . . . . . . 10,000
Old equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Gain on disposal of equipment . . . . . . . . . . . . . 2,000
Zhang
General Journal
New equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,000
Old equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Gain on disposal of equipment . . . . . . . . . . . . . 6,000
b.
Prabhu
General Journal
New equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,000
Old equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Zhang
General Journal
New equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000
Old equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
c.
Prabhu
General Journal
New equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,000
Old equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
Loss on disposal of equipment . . . . . . . . . . . . . . . . 3,000
NOTE: Loss must be recorded, as the asset acquired cannot be recorded at an amount
greater than its fair value.
Zhang
General Journal
New equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,000
Old equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000
EXERCISE 9–5
Transaction 1:
IFRS requires assets acquired in exchange for the company’s shares to be reported at the
fair value of the asset acquired. The list price is not relevant, as the salesman has already
indicated that this can be negotiated downward. If the $80,000 negotiated price is considered
a reliable representation of the fair value of the asset, this amount should be used:
General Journal
Computer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000
Common shares . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000
If the $80,000 price is not considered a reliable fair value, then the fair value of the shares
given up ($78,750) should be used, as the shares are actively traded.
Transaction 2:
The asset acquired by issuing a non-interest bearing note needs to be reported at its fair value.
As the interest rate of zero is not reasonable, based on market conditions, the payments for
the asset need to be adjusted to their present value to properly reflect the current fair value of
the asset.
General Journal
Office furniture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46,284
Note payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41,284
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
The note payable amount represents the present value of a $45,000 payment due in one year,
discounted at 9%.
EXERCISE 9–6
a. Deferral Method
General Journal
Office condo . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 625,000
Deferred grant . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 535,000
b. Offset Method
General Journal
Office condo . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 535,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 535,000
c. The deferral method will result in annual depreciation expense of $625,000 ÷ 30 years
= $20,833, with an offsetting annual grant income amount recognized = $90,000 ÷ 30
years = $ 3,000 per year.
The offset method will result in an annual depreciation expense of $535,000 ÷ 30 years
= $17,833 with no grant income being recognized.
The net difference in net income between the two methods is zero.
EXERCISE 9–7
General Journal

Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44,444
Dec 31 2019 Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94,444

(1,250,000 − (1,200,000 − 44,444))
NOTE: Depreciation expense = $1,200,000 ÷ 27 years remaining = $44,444
General Journal

Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48,077
Dec 31 2020 Revaluation surplus (OCI) . . . . . . . . . . . . . . . . . . . . . 201,923

Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 201,923
(1,000,000 − (1,250,000 − 48,077))
NOTE: Depreciation expense = $1,250,000 ÷ 26 years = $48,077

General Journal

Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000
Dec 31 2021 Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190,000

(1,150,000 − (1,000,000 − 40,000))
NOTE: Depreciation expense = $1,000,000 ÷ 25 years = $40,000
EXERCISE 9–8
General Journal
Dec 31 2020 Loss in value of investment property . . . . . . . . . . . 50,000
Investment property . . . . . . . . . . . . . . . . . . . . . . . . 50,000

EXERCISE 9–9
General Journal
Repairs and maintenance . . . . . . . . . . . . . . . . . . . . . 32,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000
Accumulated depreciation – building . . . . . . . . . . . 16,302

Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108,696
Loss on disposal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92,394
The replacement of the boiler should be treated as the disposal of a separate component. The
original cost of the old boiler can be estimated as follows:
$125,000 ÷ (1 + 0.15) = 108,696
The old boiler would have been depreciated as part of the building as follows:
108,696 ÷ 40 years = 2,717 per year

2,717 × 6 years (2014–2019) = 16,302
(NOTE: per company policy, no depreciation is taken in the year of disposal)
The purchase of the new boiler should be treated as a separate component:
General Journal
Boiler . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125,000

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000
Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87,000
This cannot be identified as a separate component, but it does extend the useful life of the
asset, so capitalization is warranted.
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . 15,332

Accumulated depreciation – building . . . . . . . 15,332
Original depreciation: $800,000 ÷ 40 years = $20,000 per year

Up to the end of 2019 = $120,000 (6 years)
Based on the journal entries above, revised depreciation is calculated as follows:
800,000 − 120,000 − 108,696 + 16,302 + 87,000

= 15,332
40 − 6 + 10 = 44 years
General Journal
Accumulated depreciation – boiler. . . . . . . . . . 2,841
(125,000 ÷ 44)
NOTE: the boiler has been depreciated over the same useful life as the building (44 years). As
this is a separate component, a different useful life could be determined by management and
used instead. Per company policy a full year of depreciation is taken in the year of acquisition.
Chapter 10 Solutions
EXERCISE 10–1
a. Straight line:
125,000 − 10,000
= $23,000 per year (same for all years)
5 years
b. Activity based on input:
125,000 − 10,000
= $11.50 per hour of use
10,000 hours
2021 depreciation = $11.50 × 2,150 hours = $24,725
c. Activity based on output:

125,000 − 10,000
= $0.115 per unit produced
1,000,000 units
2021 depreciation = $0.115 × 207,000 units = $23,805
d. Double declining balance:

100
Rate = × 2 = 40%
5 years
2020 Depreciation: $125,000 × 40% = $50,000

2021 Depreciation:($125,000 − $50,000) × 40% = $30,000
EXERCISE 10–2
Depreciation rate (assume straight-line unless otherwise indicated):
10,000 − 1,000
= $3,000 per year
3 years
Depreciation per year calculated as follows:
2020: $3,000 × 6 ÷ 12 $1,500

2021: Full year $3,000
2022: Full year $3,000
2023: $3,000 × 6 ÷ 12 $1,500
Total depreciation: $9,000
(Note: in 2023, only 6 months depreciation can be recorded, as the asset has reached the end
of its useful life.)
EXERCISE 10–3
a. No journal entry is required as this is considered a change in estimate. Depreciation will

be adjusted prospectively only, with no adjustment made to prior years.
b. Original depreciation:
$39,000 − $4,000
= $7,000 per year
5 years
Depreciation taken 2018–2020 = $7,000 × 3 years = $21,000
Revised depreciation for 2021 and future years:
$39,000 − $21,000 − $5,000

= $3,250 per year
7 years − 3 years = 4
General Journal
EXERCISE 10–4
a. Depreciation from 2006–2011:
$450,000 − $90,000
= $12,000 per year
30 years
Total depreciation taken = $12,000 × 6 years = $72,000
b. Depreciation from 2012–2019:
$450,000 − $72,000 + $30,000 − $50,000

= $10,529 per year
30 − 6 + 10 years = 34
Total depreciation taken = $10,529 × 8 years = $84,232
c. Depreciation for 2020 and future years:
$450,000 + $30,000 − $72,000 − $84,232

= $12,453 per year
34 − 8 = 26 years
EXERCISE 10–5
a. Determine the recoverable amount:
Value in use = $110,000

Fair value less costs of disposal = $116,000
The recoverable amount is the greater amount: $116,000

Carrying value = $325,000 − $175,000 = $150,000
As the carrying value exceeds the recoverable amount, the asset is impaired by $150,000−
$116,000 = $34,000
b.
General Journal
c. New carrying value = $150,000 − $34,000 = $116,000
$116,000 − 0
Depreciation = = $38,667
3 years
General Journal
d. Determine the recoverable amount:
Value in use $ 90,000

Fair value less costs to sell $111,000
The recoverable amount is the greater amount: $111,000

The carrying value is now $116,000 − $38,667 = $77,333
The asset is no longer impaired. However, the reversal of the impairment loss is limited.
If the impairment had never occurred, the carrying value of the asset would have been:
Unimpaired carrying value on Jan 1, 2021 $ 150,000

Depreciation for 2021 (150,000 ÷ 3) (50,000)
Unimpaired carrying value at Dec 31, 2021 100,000
Therefore, the reversal of the impairment loss is limited to: $100,000 − $77,333 =
$22,667
The journal entry will be:
General Journal
Accumulated impairment loss . . . . . . . . . . . . . . . . . 22,667
Recovery of previous impairment loss . . . . . . 22,667
EXERCISE 10–6
a.
b. ASPE 3063 uses a two-step process for determining impairment losses. The first step
is to determine if the asset is impaired by comparing the undiscounted future cash flows
to the carrying value:
Undiscounted future cash flows: $140,000

Therefore, the asset is impaired.

The second step is to determine the amount of the impairment. This amount is the
difference between the carrying value and the fair value of the asset:

Fair value $125,000
Impairment loss $ 25,000
Thus, the journal entry will be:
General Journal
c. Depreciation will now be based on the new carrying value:
$150,000 − $25,000 = $125,000

$125,000 ÷ 3 years = $41,667 per year
General Journal
d. The carrying value is now $125,000 − $41,667 = $83,333. As this is less than the
undiscounted future cash flows, the asset is no longer impaired. However, under ASPE
3063, reversals of impairment losses are not allowed, so no adjustment can be made in
this case.
EXERCISE 10–7
a. The total carrying value of the division is $95,000. The fair values of the individual
assets cannot be determined, so the value in use is the appropriate measure. In this
case, the value in use is $80,000, which means the division is impaired by $15,000. This
impairment will be allocated on a pro-rata basis to the individual assets:

Amount Loss
Computers $55,000 55/95 $8,684
Furniture 27,000 27/95 4,263
Equipment 13,000 13/95 2,053
95,000 15,000
b. The journal entry would be:

General Journal
Accumulated impairment loss – computers . 8,684
Accumulated impairment loss – furniture . . . 4,263
Accumulated impairment loss – equipment . 2,053
c. The value in use ($80,000) is greater than the fair value less costs to sell ($60,000) so
the calculation of impairment loss is the same as in part (a) (i.e., $15,000). However,
none of the impairment loss should be allocated to the computers, as their carrying value
($55,000) is less than their recoverable amount ($60,000). The impairment loss would
therefore be allocated as follows:
Amount Loss
Furniture $27,000 27/40 $10,125
Equipment 13,000 13/40 4,875
40,000 15,000
d. The impairment loss is still calculated as $15,000. However, this time the computers are
also impaired, as their carrying value ($55,000) is greater than their recoverable amount
($50,000). In this case, the computers are reduced to their recoverable amount and the
remaining impairment loss ($15,000 − $5,000 = $10,000) is allocated to the furniture
and equipment on a pro-rata basis:

Amount Loss
Computers $55,000 $5,000
Furniture 27,000 27/40 6,750
Equipment 13,000 13/40 3,250
95,000 15,000
EXERCISE 10–8
a.
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450,000
Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950,000
b.
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 750,000
Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950,000
Gain on disposal of asset . . . . . . . . . . . . . . . . . . 230,000
c.
General Journal
Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950,000
Loss on abandonment of asset . . . . . . . . . . . . . . . . 520,000
d.
General Journal
Donation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000
Property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950,000
Gain on donation of asset . . . . . . . . . . . . . . . . . . 80,000
EXERCISE 10–9
a.
General Journal
Machine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,000
b.
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,000
Gain on sale of asset . . . . . . . . . . . . . . . . . . . . . . 3,000
c.
General Journal
Machine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,000
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,000
Chapter 11 Solutions
EXERCISE 11–1
The items below are identified as capitalized as an intangible asset or expensed, with the
account each item would be recorded to.
a. Expense as research and development expense
b. Capitalize if the development phase criteria for capitalization are all met; else expense
c. If reporting under IFRS, then capitalize the borrowing costs if the development phase
criteria for capitalization are all met; else expense; if reporting under ASPE, then a policy
choice exists for both borrowing costs and research and development costs
d. Expense as salaries and wages expense
e. Expense as marketing expenses
f. Capitalize as part of the patent asset amount
g. Expense as research expenses
h. Expense to salaries, travel etc. as incurred
i. Capitalize as part of the patent asset amount
j. Capitalize as part of the software asset amount

k. Expense as training expenses
l. Capitalize as part of the software asset amount
m. Organization expense
n. Operating expense
o. Capitalized to the franchise asset
p. Under IFRS, will be capitalized only if the development costs meet all six development-
phase criteria for capitalization; under ASPE, may be capitalized or expensed, depend-
ing on company’s policy when it meets the six criteria in the development stage
q. Capitalized to the patent asset
r. Capitalized to the patent asset
s. Capitalized to the copyright
t. Capitalized as development costs only if they meet all six development phase criteria for
capitalization.
u. Expensed to research and development expenses
v. Expensed on the income statement
w. Under IFRS, borrowing costs that are directly attributable to project that meet the six de-
velopment phase criteria are capitalized; under ASPE, interest costs directly attributable
to the project that meet the six development phase capitalization criteria can be either
capitalized or expensed as set by the company’s policies
x. Under IFRS, will be capitalized to the intangible asset only if the development costs meet
all six development-phase criteria for capitalization
y. Expensed to research and development expenses
z. Expensed to interest expenses
aa. Expensed to research and development expenses
EXERCISE 11–2
a. Intangible assets likely include:
• purchased trademark Aromatica Organica and its related internet domain name
• purchased patented soap recipes

• expenditures related to infrastructure and graphical design development of Har-
man’s unique website through which the retailers review the product offerings and
place their orders.
b. The majority of Harman’s assets are intangible. They include the Aromatica Organica
trademark, the patented soap and oil recipes, and the company’s own product and
ordering website. The intangible assets help to protect the revenues from competitor
companies, so Harman can sell a unique product with a specific brand name that cus-
tomers recognize for its fine quality and through a unique website developed by Harman.
c. The intangible assets meet the definition of an asset because they involve past and
present economic resources for which there are probable future economic benefits that
are obtained and controlled by Harman. Recording intangible assets on the company’s
SFP/BS provides users with relevant and faithfully representative information about the
company’s expected future economic benefits, as well as financial statements that are
complete and free from error or bias.
EXERCISE 11–3
Amortization
Jan 1 Carrying value 288,000 ÷ 14 years = 20,571
Sept 1 Legal fees 42,000 ÷ (4 months ÷ 160 months)* = 1,050
Total amortization for 2020 330,000 21,621
* September 1 was the date that the patent was legally upheld thus meeting the definition of
an asset subject to amortization. There are 4 months remaining in 2020 starting September
1. If on January 1, 2020 there were 14 years remaining, then as at September 1, 2020,
there would be 13 years + 4 months remaining. Converting this to months is 13 × 12 =
156 months + 4 months = 160 months. For 2020, there are 4 months to year-end to amortize
the legal fees, so 4 ÷ 160 months would be the prorated amount of the legal fees capitalized
for 2020.
Carrying amount as at Dec 31, 2020: 330,000 − 21,621 = $308,379
The accounting for the research expense of $140,000 is to be expensed when incurred be-
cause it can only be recognized from the development phase of an internal project when the
six criteria for capitalization are met.
EXERCISE 11–4
(Partial SFP/BS):
Intangible assets
Copyright – definite life, 5 years (net of amortization for $5,000) $20,000
Copyright – indefinite life 35,000
Internet domain name* – indefinite life 37,368
Liabilities
Current liabilities
Current portion of long-term note payable** $12,431
Note payable, due January 1, 2022 $13,426
* PV (14500 PMT, 8 I/Y, 3 N)

** Amortization schedule:
Cash Payment Interest 8% Amortization Balance

37,368.00
Dec 31, 2020 14,500 2989.44 11,510.56 25,857.44
Dec 31, 2021 14,500 2068.60 12,431.40 13,426.04
Dec 31, 2022 14,500 1,073.96 (rounding) 13,426.04 0
(Partial income statement):
Amortization expense ($25,000 ÷ 5 years) $5,000
Note – item (b), purchased copyright and item (c), purchased Internet domain name have
indefinite useful lives so they would not be amortized.
EXERCISE 11–5
a. Under ASPE, Trembeld has the option either to expense all costs as incurred or to
recognize the costs as an internally generated intangible asset when the six development
phase criteria for capitalization are met. If Trembeld expenses all costs as incurred, they
will be expensed as research and development expenses.
Research and development expense* 634,000
*$180,000 + 64,000 + 270,000 + 86,000 + 25,400 + 8,600

If Trembeld chooses, it can capitalize all costs incurred after April 1. The costs incurred
prior to April 1 must be expensed as research and development expenses.
Intangible assets – development costs* 390,000

Research and development expense ($180,000 + $64,000) 244,000
* $270,000 + 86,000 + 25,400 + 8,600 = $390,000

Note: Under ASPE, once interest costs directly attributable to the acquisition, con-
struction, or development of an intangible asset meet the six criteria to be capitalized,
they may be capitalized or expensed depending on the company’s accounting policy for
borrowing costs.
b. If Trembeld followed IFRS, all costs associated with the development of internally gener-
ated intangible assets would be capitalized when the six development phase criteria for
capitalization are met. The costs incurred prior to the date the required criteria were met
would be expensed as research and development expense.
Intangible assets – development costs* 390,000

Research and development expense ($180,000 + $64,000) 244,000
* $270,000 + 86,000 + 25,400 + 8,600 = $390,000
EXERCISE 11–6
a. Under ASPE
Recoverability test:
The undiscounted future cash flows of $152,000 < the carrying amount $100,500, there-
fore the asset is impaired.
The impairment loss is calculated as the difference between the asset’s carrying amount
$100,500 and fair value $55,000.
In this case, the undiscounted future cash flows ($152,000) > Carrying amount ($100,500),
therefore the asset is not impaired.
b. Under IFRS
If carrying amount $100,500 > recoverable amount $115,000 (where recoverable amount
is the higher of value in use $115,000 and fair value less costs to sell $50,000), the asset
is impaired.
The impairment loss is calculated as the difference between carrying amount $100,500
and recoverable amount $115,000.
In this case, the carrying amount $100,500 is < the recoverable amount of $115,000 so
there is no impairment loss.
c. Under ASPE, for indefinite-life intangible assets:

If the carrying amount $100,500 > the asset’s fair value $55,000, then the asset is
impaired.
The impairment loss is calculated as $45,500 ($100,500 − $55,000).
Under IFRS, there is no impairment loss as the carrying amount of $100,500 < the
recoverable amount of $115,000 (where recoverable amount is the higher of value in
use and fair value less costs to sell).
EXERCISE 11–7
Fair Value % of Total × Cost = Recorded

Amount
(rounded)
Trade name $380,000 30.89% $1.2 million $370,680
Patented process 400,000 32.52% $1.2 million 390,240
Customer list 450,000 36.59% $1.2 million 439,080
$1,230,000 $1.2 million
General Journal
Intangible assets – trade names . . . . . . . . . . . . . . . 370,680
Intangible assets – patented process . . . . . . . . . . 390,240
Intangible assets – customer list . . . . . . . . . . . . . . . 439,080
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200,000
Note: The asset purchase is to be capitalized using the relative fair value method and assets
separately reported so that the amortization expense can be separately determined for each
based on their respective useful life.
EXERCISE 11–8
a. At December 31, 2020, Bartek reports the patent:
Intangible assets
Patent $800,000
Accumulated amortization* 425,000
$375,000
* Amortization 2017 to 2019: $800,000 ÷ 8 × 3 years = $300,000
Amortization for 2020:
(Remaining carrying value − revised residual value)

Remaining useful life
(800,000 − 300,000) − 0 residual value

= 125,000
(7 − 3 )
Accumulated amortization 2017 to 2020: (300,000 + 125,000) = $425,000
b. The amount of amortization of the franchise for the year ended December 31, 2019, is
$25,000: ($500,000 ÷ 20 years). Reason: Bartek should amortize the franchise over
20 years which is the period of the identifiable cash flows. Even though the franchise is
considered as “perpetual,” the company believes it will generate future economic benefits
for only the next 20 years.
c. Unamortized development costs would be reported as $50,000 ($250,000 net of $200,000

accumulated amortization) at December 31, 2020 on the SFP/BS.
Amortization for 2017 to 2020: $250,000 ÷ 5 years × 4 years = $200,000
EXERCISE 11–9
a.
Cash purchase price

$863,000
Fair value of assets $1,160,000
Less liabilities (carrying value = fair value) (460,000)
Fair value of net assets 700,000
Value assigned to goodwill $163,000
b. Under IFRS, the recoverable amount of the CGU of $1,850,000 (which is the greater of
the fair value, less costs to sell $1,600,000, and the value in use $1,850,000) is compared
with its carrying amount $1,925,000 to determine if there is any impairment.
The goodwill is impaired because carrying amount of the CGU $1,925,000 > recoverable
amount of the CGU $1,850,000. The goodwill impairment loss is $75,000 ($1,925,000 −
$1,850,000). A reversal of an impairment loss on goodwill is not permitted.
c. Under ASPE, goodwill is assigned to a reporting unit at the acquisition date. Goodwill
is tested for impairment when events or changes in circumstances indicate impairment
may exist. An impairment exists if the carrying amount of the reporting unit $1,925,000
exceeds the fair value of the reporting unit $1,860,000. In this case there is an impair-
ment loss of $65,000 ($1,925,000 − $1,860,000). A reversal of an impairment loss on
goodwill is not permitted.
EXERCISE 11–10
a. Goodwill as a separate line item on the SFP/BS

b., c., d. Research costs, organization cost, and the annual franchise fee would be
classified as operating expenses
e., f., g., h. Cash, accounts receivable, notes receivable due within one year from balance
sheet date and prepaid expenses would be classified as current assets
i. Intangible assets, if development criteria met at the acquisition date
j. Non-current assets in the tangible property, plant, and equipment section.
(Some accountants classify them as intangible assets on the basis that the
improvements revert to the lessor at the end of the lease and therefore are
more of a right than a tangible asset.)
k. Intangible assets
l. Intangible assets
m. Investments section on the SFP/BS
n. Intangible assets
o. Discount on notes payable is shown as a deduction from the related notes
payable on the SFP/BS as a liability
p., q. Long-term assets in the tangible property, under plant, and equipment section
r. Intangible asset
s. Intangible asset
t. Goodwill as a separate line item on the SFP/BS
u. Expensed as part of research and development expense. (Development
expenses are expensed unless all six criteria for capitalization are met.)
EXERCISE 11–11
a. The determination of useful life by management can have a material effect on the bal-
ance sheet as well as on the income statement. The following are the variables to
consider when determining the appropriate useful life for a limited-life intangible.
• The legal life for a patent in Canada is twenty years but management can deem a
shorter useful life based on
– the expected use of the patent
– economic factors such as demand and competition
– the period over which its benefits are expected to be provided.
• The estimated useful life of the patent should be based on neutral and unbiased
consideration of the factors above, which requires a degree of professional judg-
ment.
b. December 31, 2019:

Amortization: $25,000 ÷ 20 = $1,250
Carrying amount: $25,000 − $1,250 = $23,750
December 31, 2020:
Amortization: $1,250 + ($35,000 ÷ 18.5 × (6 ÷ 12)) = $2,196 (rounded)
Carrying amount: $23,750 + $35,000 − $2,196 = $56,554
c. Dec 31, 2019 carrying amount from (b): $23,750
2020 amortization: ($23,750 ÷ (15 − 1)) + ($35,000 ÷ (15 − 1.5)) × (6 ÷ 12) = $2,993
(rounded)
Carrying amount: $23,750 + $35,000 − $2,993 = $55,757
d. If it has an indefinite life, then do not amortize. If classified as indefinite life, management
must review useful life annually to ensure that conditions and circumstances continue to
support the indefinite life assessment. Any change in useful life is to be accounted as a
change in estimate, which is accounted for prospectively. Also, management would have
to test annually for impairment or whenever indicators of such a possibility exist.
EXERCISE 11–12
a. Situation (i) Journal Entries:

General Journal
Jan 1 2020 Intangible assets – patents . . . . . . . . . . . . . . . . . . . . 900,000
Cash, accounts payable, etc. . . . . . . . . . . . . . . . 900,000
Dec 31 2020 Amortization expense . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Accumulated amortization, patents . . . . . . . . . 60,000
(900,000 ÷ 15)

Accumulated amortization, patents . . . . . . . . . 84,000
((900,000 − 60,000) ÷ 10)
Situation (ii) Journal Entries:

General Journal
2020 Research and development expenses . . . . . . . . . 180,000
2020 Intangible assets – electronic product . . . . . . . . . . 170,000


Accumulated amortization, electronic prod- 17,000
uct . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
(170,000 ÷ 10)
Situation (iii) Journal Entries:

General Journal
Jan 1 2020 Intangible assets – franchise . . . . . . . . . . . . . . . . . . 1,800,000
Cash, accounts payable, etc. . . . . . . . . . . . . . . . 1,800,000

Accumulated amortization – franchise . . . . . . 45,000
(1,800,000 ÷ 40)
Dec 31 2020 Franchise fee expense . . . . . . . . . . . . . . . . . . . . . . . . 112,000

($5.6 million × 2%)
Situation (iv) Journal Entries:

General Journal
2020 Research and development expenses . . . . . . . . . 290,000
($25,000 + 250,000 + 15,000)
b. Partial income statement:

Hilde Co.
Statement of Income (partial)
For the Year Ending December 31, 2020
Revenue from franchise $5,600,000

Expenses
Research and development expenses* $470,000
Franchise fee expense 112,000
Amortization expense** 122,000 704,000
Income from operations before taxes 4,896,000
Income tax expense 1,321,920
Net income $3,574,080
* ($180,000 + 290,000)
** ($60,000 + 17,000 + 45,000)
Partial balance sheet:

Hilde Co.
Balance Sheet (partial)
Intangible assets:
Intangible assets – patents $ 900,000
Accumulated amortization 60,000 $ 840,000
Intangible assets – electronic product 170,000
Accumulated amortization 17,000 153,000
Intangible assets – franchise 1,800,000
Accumulated amortization 45,000 1,755,000
Total intangible assets $2,748,000
Note: The balance sheet reporting requirement is to disclose the net amount for each
intangible asset separately, its related accumulated amortization, any accumulated im-
pairment losses, and a total for net intangible assets. With these requirements in mind,
an alternative reporting format for the balance sheet would be to report the net amounts
for each intangible asset as shown in the right-hand column with disclosure of the
accumulated amortization, any accumulated impairment losses and the net amount for
each intangible asset in an additional schedule in the notes to the financial statements.
c. Under IFRS, if the costs meet the six development phase criteria for capitalization, then
they are to be capitalized. Under ASPE, costs that meet the six development phase
criteria for capitalization may either be capitalized or expensed, depending on the entity’s
accounting policy. In this case, Hilde’s policy is to capitalize costs that meet the criteria;
therefore, the accounting entries would be the same as the solution above.
Under IFRS there is an option to use the revaluation model for subsequent measurement
of intangible assets after acquisition if there is an active market for the intangible assets.
Refer to the chapter on property, plant, and equipment for details about this model. In
addition, under IFRS, an assessment of estimated useful life is required at each reporting
date.
d. Impairment testing for limited-life assets under ASPE:

Limited-life intangible assets would be tested for possible impairment whenever events
and circumstances indicate the carrying amount may not be recoverable. The carrying
amount of the asset is compared to undiscounted future net cash flows of the asset,
to determine if the asset is impaired. If impaired, the difference between the asset’s
carrying amount and its fair value will be the impairment amount. Under ASPE, an
impairment loss for intangible assets may not be reversed.
Impairment testing for limited-life intangibles under IFRS:
At the end of each reporting period, the asset is to be assessed for possible impairment.
If impairment is suspected, and the carrying amount is higher than the recoverable
amount (which is the higher of the value in use, and the fair value less costs to sell), the
asset is impaired. The impairment loss is the difference between the asset’s carrying
amount and its recoverable amount. Under IFRS, an impairment loss may be reversed
in the future, although the reversal is limited to what the asset’s carrying amount would
have been had there been no impairment.
EXERCISE 11–13
Entry:
General Journal
Intangible asset – patent . . . . . . . . . . . . . . . . . . . . . . 107,666
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
Note payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57,666*
For Intangible asset: ($50,000 + $57,666)
* Present value calculation:
PV = (4,800** PMT, 9 I/Y***, 5 N, 60,000 FV)

PV = $57,666 (rounded)
** $60,000 × 8%
*** PV calculations use the market rate while the interest payment of $4,800 uses the stated
rate.
EXERCISE 11–14
a.
General Journal
2020 Research and development expense . . . . . . . . . . 150,000
Intangible assets – patents . . . . . . . . . . . . . . . . . . . . 20,000

Amortization expense . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Accumulated amortization. . . . . . . . . . . . . . . . . . 2,000
(20,000 ÷ 10 years (2020–2030))
2021 Intangible assets – patents . . . . . . . . . . . . . . . . . . . . 22,000

Amortization expense . . . . . . . . . . . . . . . . . . . . . . . . . 2,857

Accumulated amortization. . . . . . . . . . . . . . . . . . 2,857
((20,000 + 22,000 − 2,000) ÷ 14)
2022 Research and development expense . . . . . . . . . . 250,000

Intangible assets – development costs . . . . . . . . . 50,000

b. Under IFRS, costs associated with the development of internally generated intangible
assets are capitalized when the six specific criteria for capitalization are met in the
development stage. The $250,000 must be expensed as it was incurred before the
future benefits were reasonably certain. Costs incurred after the six specific criteria
for capitalization are met, are capitalized. The $50,000 costs incurred indicates the
company’s intention and ability to generate future economic benefits. As a result, the
$50,000 would be capitalized as development costs. The $50,000 capitalized costs
would be amortized over periods benefiting after manufacturing begins.
EXERCISE 11–15
a. Impairment for limited-life under IFRS:

Carrying value: 1,000,000
Recoverable amount: higher of value in use and fair value less costs to sell
= higher of [$1,100,000 and ($1,000,000 − 45,000 = 955,000)] = 1,100,000
Carrying value is less than 1,100,000, therefore the franchise is not impaired.
b. Carrying value: 1,000,000

Recoverable amount: 950,000
Carrying value is more than the recoverable amount therefore the franchise is impaired
by $50,000.
General Journal
Accumulated impairment losses – franchise 50,000
c. Carrying value: 1,000,000

= higher of [$1,100,000 and ($1,350,000 − 45,000 = 1,305,000)] = 1,305,000
d. Under IFRS, indefinite-life intangible assets are tested for impairment annually (even
if there is no indication of impairment), which is the same as was done for limited-life
intangible assets. So the answers in parts (a) to (c) will not change because the franchise
has an unlimited life.
e. Under ASPE for limited-life intangibles, if there is reason to suspect impairment, then
management can complete an assessment of the franchise. If the carrying value is
greater than the undiscounted cash flows then it is impaired. The impairment amount is
the difference between the carrying value and the fair value.
Part (a) Carrying value: 1,000,000
Undiscounted future cash flow = 1,200,000
Part (b) Carrying value: 1,000,000
Recoverable amount (discounted future cash flows) = 950,000
Carrying value is more than the recoverable amount therefore the franchise is impaired
by $50,000.
General Journal
Accumulated impairment losses – franchise 50,000
Part (c) Fair value changed to $1.35 million. Fair value is not relevant for ASPE to assess
recoverability, so the answer does not change from part (b).
f. Part (a) Under ASPE, indefinite-life intangible assets are tested for impairment when
circumstances indicate that the asset may be impaired same as with limited-life intangi-
bles. However, the test differs from the test for limited-life assets. Here, a fair value test
is used, and an impairment loss is recorded when the carrying amount exceeds the fair
value of the intangible asset.
Carrying value: 1,000,000

Fair value: 1,000,000
Carrying value is equal to the fair value for 1,000,000; therefore, the franchise is not
impaired.
Part (b) Under ASPE, the recoverable amount refers to undiscounted future cash flows,
which does not affect the impairment test for indefinite-life intangible assets, which com-
pares the carrying value to the fair value of the asset. The fair value remains at 1,000,000,
therefore the asset is not impaired.
Part (c) Carrying value: 1,000,000
Fair value: 1,350,000
Carrying value is less than the fair value for 1,350,000, therefore the franchise is not
impaired under ASPE for an indefinite-life asset.
EXERCISE 11–16
a.
General Journal
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000
Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000
Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95,000
Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Goodwill . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,000
Note payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230,000
b. Payment of total consideration of $280,000 for Candelabra resulted in payment for good-
will of $65,000. Goodwill is defined as an asset representing the future economic bene-
fits arising from other assets acquired in a business combination that are not individually
identified or separately recognized. In paying for goodwill of $65,000, Boxlight may have
considered the value of Candelabra’s established customers for repeat business, the
company’s reputation, the competence and ability of its management team to strategize
effectively, its credit rating with its suppliers, and whether the company has highly qual-
ified and motivated employees. Together, these could make the value of the business
greater than the sum of the fair value of its net identifiable assets.
c.

Fair value 180,000
Impairment amount 20,000
Entry:
General Journal
Accumulated impairment losses – goodwill . 20,000
d.
Carrying value: 180,000
= higher of [$170,000 and ($160,000 − 10,000 = 150,000)] = 170,000
Carrying value is greater than 170,000; therefore, the franchise is impaired by $10,000
(180,000 − 170,000).
General Journal
Accumulated impairment losses – goodwill . 10,000
Note: Had the impairment amount exceeded the $65,000 goodwill carrying value, the
amount of the difference would be allocated to the remaining net identifiable assets on a
prorated basis.
e. For part (c), reversal of goodwill if impairment losses exist is not permitted under ASPE.
For part (d), reversal of goodwill impairment losses is not permitted under IFRS.
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Author: G. Arnold, S. Kyle

Publisher: Lyryx Learning Inc.

Book title: Intermediate Financial Accounting, Volume 1

Book version: 2021A

Publication date: December 15, 2020

Location: Calgary, Alberta, Canada

Book URL: https://lyryx.com/intermediate-financial-accounting-volume-1/

For questions or comments please contact [email protected]

2019 A • Text updated throughout to reflect new IFRS rules in 2019.

Table of Contents iii

1 Review of Intro Financial Accounting 1

Chapter 1 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

1.1 Adjusting and Closing Entries . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

1.2 Merchandising Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

1.3 Inventory Costing Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

1.4 Bank Reconciliations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

1.5 Receivables Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

1.6 Long-Lived Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

1.7 Current and Long-Term Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . 3

1.8 Statement of Cash Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Chapter 2 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

2.1 Definition and Information Asymmetry . . . . . . . . . . . . . . . . . . . . . . . 7

2.3 How Are Standards Set? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

2.4 The Conceptual Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

2.4.1 The Objective of Financial Reporting . . . . . . . . . . . . . . . . . . . . 12

2.4.2 Qualitative Characteristics of Useful Information . . . . . . . . . . . . . . 12

2.4.3 Elements of Financial Statements . . . . . . . . . . . . . . . . . . . . . 16

2.4.5 Measurement Base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

2.4.6 Capital Maintenance . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

2.5 Challenges and Opportunities in Financial Reporting . . . . . . . . . . . . . . . 22

2.7 IFRS/ASPE Key Differences . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

3 Financial Reports: Statement of Income, Comprehensive Income and Changes in

Chapter 3 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

3.1 Financial Reporting: Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

3.2 Factors that Influence Financial Reports . . . . . . . . . . . . . . . . . . . . . . 40

3.2.1 Accounting Year-end . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

3.2.2 Changes in Accounting Estimates, Changes in Accounting Policy, and

3.3 Financial Statements and Their Interrelationships . . . . . . . . . . . . . . . . . 44

3.3.1 Financial Statement Differences Between IFRS and ASPE . . . . . . . . 48

3.4 Statement of Income and Comprehensive Income . . . . . . . . . . . . . . . . 48

3.5 Statement of Changes in Equity (IFRS) and Statement of Retained Earnings

3.6 Analysis of Statement of Income and Statement of Changes in Equity . . . . . . 60

3.7 IFRS and ASPE Applicable Standards . . . . . . . . . . . . . . . . . . . . . . . 62

4 Financial Reports – Statement of Financial Position and Statement of Cash Flows 75

Chapter 4 Learning Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76

4.1 Financial Reports: Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78

4.2 Statement of Financial Position/Balance Sheet . . . . . . . . . . . . . . . . . . 80

4.2.1 Disclosure Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . 80

4.2.2 Factors Affecting the Statement of Financial Position/Balance Sheet (SFP/BS) 91

4.3 Statement of Cash Flows (SCF) . . . . . . . . . . . . . . . . . . . . . . . . . . 96

4.3.1 Preparing a Statement of Cash Flows . . . . . . . . . . . . . . . . . . . 98

4.3.2 Disclosure Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . 109